University of Pennsylvania Carey Law School University of Pennsylvania Carey Law School Penn Law: Legal Scholarship Repository Penn Law: Legal Scholarship Repository Faculty Scholarship at Penn Law 2007 Hedge Funds and Governance Targets Hedge Funds and Governance Targets William W. Bratton University of Pennsylvania Carey Law School Follow this and additional works at: https://scholarship.law.upenn.edu/faculty_scholarship Part of the American Politics Commons, Banking and Finance Law Commons, Business Law, Public Responsibility, and Ethics Commons, Business Organizations Law Commons, Corporate Finance Commons, Economic Policy Commons, Finance Commons, Law and Economics Commons, and the Work, Economy and Organizations Commons Repository Citation Repository Citation Bratton, William W., "Hedge Funds and Governance Targets" (2007). Faculty Scholarship at Penn Law. 862. https://scholarship.law.upenn.edu/faculty_scholarship/862 This Article is brought to you for free and open access by Penn Law: Legal Scholarship Repository. It has been accepted for inclusion in Faculty Scholarship at Penn Law by an authorized administrator of Penn Law: Legal Scholarship Repository. For more information, please contact [email protected].
Transcript
University of Pennsylvania Carey Law School University of Pennsylvania Carey Law School
Penn Law: Legal Scholarship Repository Penn Law: Legal Scholarship Repository
Faculty Scholarship at Penn Law
2007
Hedge Funds and Governance Targets Hedge Funds and Governance Targets
William W. Bratton University of Pennsylvania Carey Law School
Follow this and additional works at: https://scholarship.law.upenn.edu/faculty_scholarship
Part of the American Politics Commons, Banking and Finance Law Commons, Business Law, Public
Responsibility, and Ethics Commons, Business Organizations Law Commons, Corporate Finance
Commons, Economic Policy Commons, Finance Commons, Law and Economics Commons, and the Work,
Economy and Organizations Commons
Repository Citation Repository Citation Bratton, William W., "Hedge Funds and Governance Targets" (2007). Faculty Scholarship at Penn Law. 862. https://scholarship.law.upenn.edu/faculty_scholarship/862
This Article is brought to you for free and open access by Penn Law: Legal Scholarship Repository. It has been accepted for inclusion in Faculty Scholarship at Penn Law by an authorized administrator of Penn Law: Legal Scholarship Repository. For more information, please contact [email protected].
Corporate governance interventions by hedge fund shareholders are triggeringdebates between advocates of management empowerment and advocates of aggres-sive monitoring by actors in the capital markets. This Article intervenes with anempirical question: What, based on the record so far, have the hedge funds actuallydone to their targets? Information has been collected on 130 domestic firms identi-fied in the business press since 2002 as targets of activist hedge funds, including thefunds’ demands, their tactics, and the results of their interventions for the targets’governance and finance. The survey results show that the hedge funds have anenviable record in getting targets to accede to their demands, using the proxy systemwith remarkable, perhaps unprecedented, success. If the pattern of interventionpersists in time, expands its reach, and maintains the present high level of gover-nance success, then the separation of ownership and control will become a lessacute problem for corporate law. Such a change will occur, however, only to theextent that clear cut financial incentives encourage an expanded field of interven-tion. To get a sense of the sample’s bearing on the question as to such incentives’existence, returns from hedge fund engagement with the sample firms are comparedto returns from market indices. The results are mixed. The answer to the questionwhether the activists have beaten the market depends on the assumptions one bringsto the comparison. But it at least can be argued that the hedge funds have not beatenthe market respecting the targets in the sample. A question accordingly arisesrespecting the depth and durability of any shift in the balance of corporate powerstemming from hedge fund activism. Meanwhile, the financial results also show thathedge fund activism is a more benign phenomenon than its critics would have usbelieve. Hedge fund interventions neither amount to near-term hold ups nor revivethe 1980s leveraged restructuring. Short term investments are rare. Large cashpayouts have been made by only a minority of the firms surveyed, and borrowing hasbeen the mode of finance in only a minority of the payout cases.
On July 26, 2004, Mylan Laboratories, a generic drug producer, announcedits agreement to acquire another drug company, King Pharmaceuticals, in astock for stock merger. The deal valued King at $16.66 per share,1 a generous61.8% premium over its day-before market price. Too generous, thought tradersin Mylan stock, which promptly dropped from $18.51 to $15.51. But Mylanstock had at least one buyer that day, Carl Icahn, who purchased one millionshares. He continued buying over the next six weeks, investing $307 millionand finally revealing himself as the owner of 6.8% of the company in aSecurities and Exchange Commission (SEC) 13D filing. He simultaneouslydenounced the deal as an overpriced acquisition of a weak company andannounced his intention to mount a proxy fight against it at the shareholders’meeting to be convened for its approval.2 Icahn got what he wanted withouthaving to incur the cost to solicit proxies; Mylan itself terminated the agreementin January 2005, citing adverse facts discovered in the due diligence process.3
Complications arose along the way. Icahn’s frontal attack on the merger puthim at odds with other Wall Street players. In the wake of a merger announce-ment, the more usual “risk arbitrage” move is to buy shares of the target (so asto benefit from any increase in the merger price) and simultaneously sell sharesof the acquirer short (so as to benefit from any further decline in its price due tothe merger). Richard C. Perry, a hedge fund manager and risk arbitrage player,did just that in Mylan’s case, but with a twist. Wishing to protect the merger(and thus his investment), he purchased Mylan stock in an amount matching hisshort position, thereby gaining control of 10% of the votes at the upcomingmeeting.4 Icahn called a foul on the grounds that Perry’s long/short position lefthim without an economic interest in Mylan. It followed, said Icahn, that Perry,despite his record ownership, should not have the privilege to vote the shares.“Corporate democracy,” he wrote, “is a cornerstone of our capitalist system. Afew hedge funds should not be permitted to destroy it in order to make a fewextra bucks.”5 Icahn sued, but the merger’s cancellation mooted the matter.6
1. Mylan Labs. Inc., Mylan Laboratories To Acquire King Pharmaceuticals (Form 425), at 1–2 (July26, 2004).
2. Mylan Labs. Inc. (Schedule 13D) (Sept. 7, 2004) (filed by Carl C. Icahn et al.); Mylan Labs. Inc.,Preliminary Proxy Soliciting Materials (Schedule 14A) (Sept. 8, 2004) (filed by Carl C. Icahn et al.).
3. Mylan Labs. Inc., Mylan Comments on King Transaction (Form 425) (Jan. 12, 2005).4. Mylan Labs. Inc., (Schedule 13D) (Nov. 29, 2004) (filed by Steve Perry Corp. et al.).5. Mylan Labs. Inc., Additional Definitive Preliminary Proxy Soliciting Materials (Schedule 14A)
(Dec. 6, 2004) (filed by Carl C. Icahn et al.).6. See High River Ltd. P’ship v. Mylan Labs., Inc., 383 F. Supp. 2d 660 (M.D. Pa. 2005). The SEC is
investigating whether Perry violated disclosure rules. See Andrew Ross Sorkin, S.E.C. Plans To AccuseHedge Fund of Violations, N.Y. TIMES, Jan. 11, 2006, at C3.
2007] 1377HEDGE FUNDS AND GOVERNANCE TARGETS
Icahn’s challenge to Perry’s votes raised an important question about the lawof shareholder voting, a question well-investigated elsewhere.7 This Articleconcerns what happened at Mylan after the merger’s cancellation.
Icahn, looking for a few extra bucks himself, did not go away. Backed by areport prepared by an industry consultant, he had already attacked Mylan’swider business strategy. The company, said Icahn, should be sold. Indeed, heannounced his willingness to buy it for $20 per share. He added that thecompany’s board needed more outside directors and that it paid its chiefexecutive officer more than the performance record justified.8 He announced hisintention to propose an opposition slate of directors at Mylan’s 2005 annualmeeting. Its managers responded by delaying the meeting and amending itsbylaws to include a preclusive advance notice requirement.9 Icahn counteredwith a second lawsuit.10
That action, too, was mooted. Mylan’s managers, seeking to satiate Icahn andneutralize his threat to their control, announced a $1.25 billion share repurchaseto be funded by a billion dollar line of credit.11 Icahn dismissively respondedthat the price they offered “for the most part” fell below his $20 offer.Nonetheless, he took his pro rata share of the buyback pot just the same,dropping both the proxy fight and the offer to purchase, and selling the rest ofhis shares into the market.12
As he made his exit from this thirteen month investment, Icahn noted thatMylan’s stock now traded 32% higher than it had prior to his appearance.13 Hedid not mention the fact that he had left behind a different company. Pre-Icahn,Mylan had $1.8 billion of shareholders’ equity and no debt. Post-Icahn, itsshareholders’ equity stood at $787 million and long-term debt at $685 million.14
While this 87% ratio of debt to equity did not make Mylan a highly-leveredcompany, it certainly left it much encumbered and correspondingly constrainedits managers’ freedom of action.
This Carl Icahn caper is a famous example of hedge fund shareholder
7. See Henry T.C. Hu & Bernard Black, The New Vote Buying: Empty Voting and Hidden (Mor-phable) Ownership, 79 S. CAL. L. REV. 811, 875–86 (2006) (recommending full disclosure respectingthe voter’s economic interest); Shaun Martin & Frank Partnoy, Encumbered Shares, 2005 U. ILL. L.REV. 775, 804–09 (recommending that economic interest be a precondition to the vote); Larry Ribstein& Bruce Kobayashi, Outsider Trading as an Incentive Device, 40 U.C. DAVIS L. REV. 21, 38–47(finding that vote-buying presents little problem and viewing disclosure as the maximal regulatoryresponse).
8. Mylan Labs. Inc., Additional Definitive Preliminary Proxy Soliciting Materials (Schedule 14A), at3–4 (Nov. 22, 2004) (filed by Carl C. Icahn et al.).
Exhibit A) (Feb. 22, 2005) (filed by Carl C. Icahn et al.).11. Mylan Labs. Inc., Current Report (Form 8-K) (June 14, 2005).12. Mylan Labs. Inc., Additional Definitive Preliminary Proxy Soliciting Materials (Schedule 14A)
(July 18, 2005) (filed by Carl C. Icahn et al.).13. Id.14. Mylan Labs. Inc., Annual Report (Form 10-K), at 40 (May 16, 2006).
1378 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
activism. Hedge funds have emerged as aggressive shareholders at many firmsin recent years. They target companies, take large positions in their stock,criticize their business plans and governance practices, and confront theirmanagers, demanding action that enhances shareholder value. When one hedgefund announces a 5% or 10% position in a company, others follow, forming a“wolf pack” that sometimes has the voting power to force management toaddress its demands. The demands, in turn, likely include one or more actionsassuring a quick return on investment—sale of the company at a premium,unbundling of the company through the sale or spin off of a large division, or alarge cash payment to the shareholders in the form of a special dividend orshare repurchase. The activists pack their biggest punch at small companieswhere their investments translate into large voting blocks. But they also haveconfronted giants like General Motors, McDonald’s, and Time Warner. Theirfinancial power has led to respectability on Wall Street, where they havebecome clients of investment banks like Lazard and UBS and law firms such asSullivan & Cromwell and Wachtell Lipton.15
Not everyone at the Wachtell firm approves, however. Its senior partner,Martin Lipton, predicts negative economic consequences: “We have,” he says,“gone from the imperial CEO to the imperial stockholder.”16 Critics like Liptonask why, between a team of managers who have been running a firm for yearsand an outside activist looking for above-market returns in the current period,the activist’s judgment about the best way to run the business should commandrespect.17 The activists, they say, survey a target with a bias toward near-termgain,18 regardless of its future, the interests of its long-term investors,19 and theproductivity of the wider economy.20 Hedge fund pressure on present andpotential targets is thought to constrain investment policy negatively,21 skewingmanagers away from promising but difficult-to-value projects toward less prom-ising but more easily valued projects. Where, as with Mylan, an activist extractsa payout financed by debt, the ongoing cash drain could leave the targetvulnerable to distress in the economy’s next downturn.22 Others warn of darkerpossibilities like lucrative side deals between unscrupulous funds and frightened
15. See Julie Fishman-Lapin, Vilified by Some, Activist Investors Promote Market Efficiency, STAM-FORD ADVO., June 4, 2006; Brent Shearer, Dangerous Waters for Dealmakers: Shareholder Sharks AreUsing Their Clout To Influence Deals, MERGERS & ACQUISITIONS, Mar. 1, 2006.
16. Battling for Corporate America—Shareholder Democracy, ECONOMIST, Mar. 11, 2006, at 160.17. Shearer, supra note 15.18. Taken as a group, the hedge funds do pursue short term returns, contributing from one-third to
one-half of daily trading volume while owning only 5% of total assets. Marcel Kahan & Edward B.Rock, Hedge Funds in Corporate Governance and Corporate Control 32–33 (Univ. of Pa. Inst. for L.& Econ., Research Paper No. 06-16, 2006), available at http://ssrn.com/abstract�919881.
19. See, e.g., Steven Schurr, Fruitless? Activist Shareholders Could Be Losing Their Ability To ShakeManagements, FIN. TIMES (London), Jan. 11, 2006, at 19.
20. See id.21. Kahan & Rock, supra note 18, at 47–50.22. Shearer, supra note 15.
2007] 1379HEDGE FUNDS AND GOVERNANCE TARGETS
managers23 or feigned interventions that create short term trading opportunities.The activists and their defenders reply with a wave of the shareholder value
banner: Given recent corporate scandals, endless discussions about supineboards of directors, and current debates over excess pay, somebody ought to beholding the managers’ feet to the fire.24 Cash payouts should be applauded:Managers should pay out capital for which the company has no good use,turning the job of reinvestment over to capital markets better suited to the task.Corporate cash payouts, while rising recently, have yet to surpass historicallevels.25 Meanwhile, the activist funds operate subject to constraints. For ex-ample, if a given fund also invests on a cooperative basis, its reputationalinterest lies in assuring that criticisms are soundly based.26 Nor does wolf packvoting always predetermine a hostile engagement’s outcome. An alternativebusiness plan must persuade the wider community of institutional investors andinformational intermediaries, many of whom can be counted on to rejectunsound, short term interventions.
This Article intervenes in this debate with an empirical question: What, basedon the record so far, have the hedge funds actually done to their targets? Toaddress the question, it collects information on 130 domestic firms identified inthe business press since 2002 as investment targets of “activist” hedge funds,surveying the funds’ demands, their tactics, and the results of their interventionsfor the targets’ governance and finance. The results show that the Mylan case isrepresentative in three respects—it is typical as regards the occasion for theintervention, the demands made, and the tactics employed. As to outcome,however, the case is an outlier; Mylan’s payout is unusual both for its magni-tude and the borrowing that financed it. Large payouts have been made by aminority of the firms surveyed, with borrowing as the mode of finance in only aminority of the payout cases. Icahn’s thirteen month round trip investment alsoturns out to be unusual; the activists more typically invest for an intermediateterm of two years or longer. Whether some stay longer still with their targetsremains to be seen, but such occurrences do not appear unlikely based on thefacts collected here.27
23. Kahan & Rock, supra note 18, at 46.24. Schurr, supra note 19, at 17.25. John Authers, Value Investing: Hoping To Update the Magic Formula, FIN. TIMES (London), Nov.
22, 2005, at 14 (noting that some economists warn against the negative impact of cash payouts whileothers argue that companies are only now finally getting payouts back to historic levels).
26. Schurr, supra note 19 (quoting fund manager David Nierenberg).27. Two draft financial economic studies based on overlapping data sets have appeared. See April
Klein & Emanuel Zur, Hedge Fund Activism (ECGI Finance, Working Paper No. 140/2006), availableat http://ssrn.com/abstract�913362; Alon Brav et al., Hedge Fund Activism, Corporate Governance,and Firm Performance (Sept. 22, 2006) (unpublished manuscript, on file with author). There also is adraft study of activist investments made by the British fund, Hermes. See Marco Becht et al., Returns toShareholder Activism: Evidence from a Clinical Study of the Hermes U.K. Focus Fund (ECGI Finance,Working Paper No. 138/2006), available at http://ssrn.com/abstract�934712. For a brief study thatreferences several cases in this Article’s sample, see David Haarmeyer, The Revolution in ActiveInvesting: Creating Wealth and Better Governance, J. APPLIED CORP. FIN., Winter 2007, at 25, 32–35.
1380 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
This Article concludes that, based on the record so far, hedge fund activism isa more benign phenomenon than its critics would have us believe. Certainly, itis uncooperative and disruptive, viewed from the point of view of a target’smanagers. But it is not a slash and burn repeat of the high leverage, bust-uptakeovers of the 1980s. Nor does it necessarily retain an uncooperative charac-ter as the engagement between a target and a fund evolves over time. Activistshave joined many target boards of directors, modifying their tactics in so doing.
That said, a question arises concerning the new activists’ potential to alterpermanently the balance of power between managers and shareholders. Berleand Means first described corporate governance as a problematic separation ofownership and control more than seventy-five years ago.28 Solutions to theproblem have been announced on two occasions since—first with the hostiletakeovers of the 1980s29 and then, more hesitantly, with the appearance ofactivist investment institutions in the 1990s.30 Both announcements provedpremature. With the hedge funds, a newly configured shareholder interestbreaches the governance divide for the third time. This Article will show thatthe activist funds have employed the proxy system, widely thought to bemoribund,31 with remarkable, perhaps unprecedented, success.32 If this patternof intervention persists in time and expands its reach, the separation of owner-ship and control could become a less acute governance problem. The analysishere, however, registers a question about the change’s depth and durability. Theseparation of ownership and control will yield only to the extent that clear cutfinancial incentives encourage shareholder intervention. This Article’s review offinancial results does not confirm the presence of such incentives. Nor, however,does it negate them.
Part I describes the data set—the characteristics of the hedge funds, theirinvestment positions, and the target companies. Part II describes the tactics thatthe hedge funds employ and the governance results, showing that the hedgefunds have an enviable success record at getting targets to accede to theirdemands, whether by force or persuasion. Part III looks at financial results—theduration of hedge fund investments in targets, levels of cost-cutting at targetfirms, levels and financing of cash payouts, and the targets’ stock marketperformances. These results, while less earth-shaking, bear importantly onpolicy debates. Short-term investments are rare. Targets have rarely been slash-
28. See ADOLF A. BERLE, JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE
PROPERTY 112–16 (William S. Hein & Co. 2000) (1933).29. William W. Bratton, Berle and Means Reconsidered at the Century’s Turn, 26 J. CORP. L. 737,
755–56 (2001).30. Bernard S. Black, Agents Watching Agents: The Promise of Institutional Investor Voice, 39
UCLA L. REV. 811, 886–88 (1992) (describing institutional voice as a partial palliative).31. See Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 HARV. L. REV. 833,
851–64 (2005) (discussing the operation of the shareholder voting system in issue-based contests);Lucian Arye Bebchuk, The Myth of the Shareholder Franchise, 93 VA. L. REV. (forthcoming 2007)(discussing data on fully prosecuted proxy contests).
32. See infra note 106 and accompanying text.
2007] 1381HEDGE FUNDS AND GOVERNANCE TARGETS
ing costs in the wake of hedge fund intervention. Cash payouts, while substan-tial, do not cripple the targets, which tend to fund them with the proceeds ofasset sales. A comparison of investment returns from hedge fund engagement toreturns from market indices yields mixed results—the answer to the questionwhether the activists have beaten the market depends on the assumptions onebrings to the exercise of comparison. However, it can at least be argued that thehedge funds have not beaten the market respecting the targets in this Article’ssample. Part IV looks at a subset of cases in which the hedge funds intervene toterminate or alter announced mergers. The success record is again impressive.In addition, with mergers, the productivity implications of the activist interven-tion are notably positive.
I. HEDGE FUNDS AND TARGETS
This Part begins by situating the activist hedge funds within the widercommunity of investment institutions. It then goes on to describe the casesample, breaking out the characteristics of the target firms and the funds’investment positions.
A. THE ACTIVIST FUNDS AND THEIR INSTITUTIONAL CONTEXT
Although hedge funds resist one-line definition, their regulatory status at themoment is clear enough: They lie outside the bounds of federal regulation of mutualfunds, other investment companies, and their advisors.33 Regulatory classification,however, does not tell us what hedge funds do. Private equity funds occupy the sameunregulated space and appeal to the same class of investors, and, like hedge funds,lever their portfolios.34 Until recently, we could distinguish hedge funds from privateequity by the characteristics of their investments. Private equity, the successor to theleveraged buyout funds of the 1980s, takes companies private, investing long-term intheir equity from a control position. Hedge funds, in contrast, play securities marketsworldwide. Private equity firms possess expertise in company analysis. Hedge funds,in contrast, employ “numbers guys” expert in complex market arbitrage.35 Differenthedge funds concentrate on different market plays. Some specialize in securities ofdistressed firms, while others make directional bets on the movement of currencyexchange or interest rates. Still others pursue convertible arbitrage, going long in a
33. Hedge funds are exempt from the Investment Company Act of 1940 because they either have100 or fewer beneficial owners and do not offer their securities to the public, see 15 U.S.C.§ 80a-3(c)(1) (2000), or because their investors are all qualifying wealthy individuals or institutions,see id. § 80a-3(c)(7). For their status under the Investment Advisers Act of 1940, 15 U.S.C. § 80b-1 to-21, see Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), which vacates and remands the SEC’s“Hedge Fund Rule.” See also Registration Under the Advisers Act of Certain Hedge Fund Advisers, 69Fed. Reg. 72,054 (Dec. 10, 2004) (codified at 17 C.F.R. pts. 275, 279). The plaintiffs in the caseincluded the governance activist Philip Goldstein and his Opportunity Partners.
34. See Kahan & Rock, supra note 18, at 30 (noting that 30% of hedge funds use a 2-to-1 leverageratio, while another 40% lever at lower ratios).
35. Irwin A. Kishner & Kacey M. Foster, The New Masters of the Buyout Universe, 234 N.Y. L.J. 11(2005).
1382 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
convertible bond and shorting the underlying common stock.36 Many follow marketmomentum, moving in groups in and out of asset classes worldwide.37 Recently,some have taken up risky lending, funding leveraged buyouts and firms in bankruptcyreorganization, and trading in junk bonds and credit derivatives.38 The tie that bindsthe hedge funds together, despite the variety of investment styles, is their promise todeliver above-market returns, a task that becomes harder and harder as more fundspursue the same strategies.
One subset of hedge funds invests in domestic equities in the classic, valueinvestor mode.39 The activist funds tend to come from this value-directed group.They maintain concentrated portfolios and often avoid the hedged or multi-strategy approaches followed by other funds,40 with their managers tending tobe former investment bankers or research analysts rather than quantitativeexperts. They do the research and know their targets well, much like the privateequity firms.41 Some of their managers even profess to be followers of Grahamand Dodd, the mid-twentieth century financial writers whose work remains afundamental text of value investment.42
But their activist interventions break with the Graham and Dodd tradition.The leading value exponent, Warren Buffett, invests long-term and stays patient,following the same cooperative strategy as the private equity investors.43 Theactivists lack this patience. They look for value but want it realized in the nearor intermediate term. Their strategy is to tell managers how to realize the valueand to challenge publicly those who resist their advice.
Private equity also actively reshapes business plans, but does so behindclosed doors over periods of years, after buying the company and taking itprivate. Differences in governing investment contracts parallel these differentbehavior patterns. Contracts governing investment in hedge funds typically lockup investor capital for six months, although some now impose terms of two
36. See A.V. Rajwade, Markets and Hedge Funds, BUS. STANDARD, Mar. 27, 2006.37. Roben Farzad, Blue Chip Blues; How Long Will the Stocks of America’s Largest Companies
Remain Weaklings on Wall Street?, BUS. WK., Apr. 17, 2006, at 21.38. Rajwade, supra note 36.39. The search for value takes them to small- and mid-capitalization companies that are under-
researched and thus passed over by mainstream investment institutions. Such stocks have becomeharder to find lately. Large-capitalization stocks have languished in recent years—over the last fiveyears, the Standard & Poor’s 500 index has returned only 4.3% per year. Farzad, supra note 37, at 66.Forward momentum in domestic equity markets has occurred only in the small- and mid-cap sectors.Valuations have compressed, making cheap stocks harder to identify, and volatility has decreased,reducing opportunities to catch a bargain. Authers, supra note 25, at 14.
40. Some of the value funds do hedge variation, following a long/short strategy, going long inundervalued stock and short in overvalued stock in search of returns independent of the direction of themarket. Rajwade, supra note 36.
41. See Fishman-Lapin, supra note 15.42. See Authers, supra note 25, at 14 (describing hedge fund participants at the Value Investing
Congress for followers of Ben Graham’s investment theory).43. See ROGER LOWENSTEIN, BUFFETT: THE MAKING OF AN AMERICAN CAPITALIST, at xiii–xvi (1995).
2007] 1383HEDGE FUNDS AND GOVERNANCE TARGETS
years or longer.44 Contracts governing private equity investment tend to lock upinvestments for five years, with some contracts going as far as ten years.45
These more liberal arrangements facilitate not only large, illiquid, and long-term equity positions, but patience. In contrast, the hedge funds’ shorter dura-tions, when coupled with the large, illiquid positions, invite aggression andimpatience. Of course, nothing in present practice dictates the terms of theactivists’ future arrangements with their investors. If they obtain longer lockups,modified strategies may follow.
The activists’ aggressive stance respecting management business decisionsalso distinguishes them from the investment managers of mutual and pensionfunds. Observers of corporate governance have spent two decades encouragingthese fund advisors to take the lead for the shareholder interest and activelychallenge the authority of unsuccessful corporate managers. But the requisitefinancial incentives never have fallen into place. Collective action problems,conflicts of interest, and investment duration all stand in the way. The free riderproblem discourages investment managers from incurring the costs of chal-lenges—gains must be shared with competitors who do not share costs. At thesame time, many fund advisors sell services to managers, importing an indepen-dent business reason to stay cooperative.46 Finally, mutual fund investors canredeem at any time, inhibiting investment in large, illiquid positions. Mean-while, the hedge funds face none of these barriers. They take investmentpositions large enough to minimize free rider problems. Gains shared within thewolf pack do not appear to inhibit the funds that take the lead in proxy fights orbring lawsuits against recalcitrant firms. The funds’ managers have every reasonto be aggressive in realizing value, earning not only 2% of assets underinvestment but 20% of the profits.47 Small size and focused strategy minimizesconflicts of interest. And, as we have seen, the governing investment contractsallow them to lock up capital for longer periods than do the mutual funds.
A final contrast between the activists and mainstream investment advisorsshould be noted. The activists, as value investors, have a better record asfinancial monitors. Only two members of the financial community challengedEnron in advance of the press. One was a Houston analyst of energy stocks.48
44. See Kishner & Foster, supra note 35, at 11. Some funds operate under caps on the percentage ofilliquid assets, putting their illiquid holdings into pockets separate from the rest of the fund. See id.; seealso Kahan & Rock, supra note 18, at 31.
45. Kishner & Foster, supra note 35, at 11.46. See, e.g., Stephen M. Bainbridge, Director Primacy and Shareholder Disempowerment, 119
HARV. L. REV. 1735, 1751–54 (2006) (describing the incentive problems of institutional investors);Kahan & Rock, supra note 18, at 20–26 (summarizing impediments to mutual managers’ ability to actas effective and activist monitors). On the free rider problem, see Jill Fisch, Relationship Investing: Willit Happen? Will it Work?, 55 OHIO ST. L.J. 1009, 1012 (1994), which observes that a rational investorwill not intervene if the effect is to confer a benefit on free-riding competitors.
47. See Rajwade, supra note 36.48. See BETHANY MCLEAN & PETER ELKIND, THE SMARTEST GUYS IN THE ROOM: THE AMAZING RISE AND
SCANDALOUS FALL OF ENRON 233–35 (2003).
1384 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
The other was Richard Grubman, the managing director of Highfields CapitalManagement, one of the leading activist firms. Grubman later would be accusedby Jeffrey Skilling in trial testimony of being the head of a short-selling ringresponsible for bringing down the company.49 The accusation was nonsense, ofcourse. Nonetheless, it is ironic now to be asking whether Grubman and otherslike him amount to a corporate governance policy problem.
B. THE SAMPLE
Appendices A and B list the firms in this Article’s sample of cases of hedge fundintervention. Each of the 130 domestic firms included was cited in the business pressbetween January 1, 2002 and June 30, 2006 as a target of an “activist” hedge fund.50
The 114 firms listed in Appendix A comprise the sample-in-chief. The row for eachtarget firm includes: (a) the year of the first such press report or, if earlier, the year ofinvestment,51 (b) the first hedge fund reported to have taken an active investmentposition, and (c) the maximum percentage of shares held by the hedge fund during itsperiod of ownership or through December 31, 2006 for continuing investments.Appendix B sets out an additional 16 firms that experienced hedge fund interventionlimited to a single merger transaction.
The search’s objective is a representative sample of active and adversaryhedge fund equity investment. Because the selection has been left to databasesof press reports, the sample is accordingly unrepresentative of hedge fundequity investment taken as a whole.52 Hedge fund shareholders can be passiveas well as active and cooperative as well as adversarial.53 The question iswhether the sample results in a skewed presentation of adversary investment, inparticular by leading to an under- or overstatement of the number of successfuloutcomes. Larger targets are probably overrepresented, larger being more news-worthy. This fact could lead to understatement of success to the extent thatlarger firms imply a higher level of difficulty. However, the rate of success turnsout to be quite high at all events. A question also comes up as to overstatementof success, assuming the hedge funds themselves engage the press in buildingreputations and challenging targets. But overstatement respecting results seemsan unlikely result of hedge fund manipulation of the press—engagement is
49. Grubman was the conference call participant who criticized Jeffrey Skilling for the firm’sbalance sheet not being ready, only to be called an “asshole.” See Andrew Clark, Enron DefendantAccuses Analyst, THE GUARDIAN (London), Apr. 14, 2006, at 26.
50. The following search request was input into the Factiva and Lexis/Nexis databases: “hedgefund” and shareholder and activist.
51. Where the commencement of hedge fund activity antedates the year of the first press report, theyear of commencement is listed if 2002 or later.
52. It should be noted that this is not a study of hedge fund investment style. For a study ofinvestment style, see generally Douglas Cumming et al., Style Drift in Private Equity (Apr. 25, 2005)(unpublished manuscript), available at http://ssrn.com/abstract�729684. This Article is a study of theinteraction between hedge funds and targets with a stress on the targets.
53. See Susan L. Barreto, Activists Aligned for Long-Term Success, HEDGEWORLD DAILY NEWS, Mar.30, 2006.
2007] 1385HEDGE FUNDS AND GOVERNANCE TARGETS
newsworthy per se, press reports tend to begin in advance of the outcome, andboth sides have access.
Two additional issues respecting the sample’s parameters need to be noted.The first concerns the characteristics of the investing fund. All of the fundswell-known in recent years for aggressive investment show up on the list.54
Some, however, might object to the “hedge fund” denomination. For example,Relational Investors, which in 2006 conducted a high-profile battle against themanagers of Sovereign Bancorp, operates solely as a long-term equity investorand runs no short positions.55 Strictly speaking, therefore, it is a fund withouthedges. As a value investor, however, it fits the profile here. Franklin MutualAdvisers, a mutual fund advisor, shows up in two cases, both times representingitself as acting on behalf of unnamed advisory clients; Morgan Stanley alsoshows up, acting on its own account.56 Their engagements’ characteristics havenot differed at all from those of the hedge funds; their targets, accordingly, havebeen left in the sample. The same goes for Tracinda, which invests KirkKerkorian’s money in businesses like casinos and movie studios and does notappear to invest on behalf of third parties. Its intervention against GeneralMotors has been grouped with those of the hedge funds by outside observersgenerally, and this Article follows suit. The sample contains, in effect, hedgefund activists and other investment institutions that act like them.
The second definitional problem concerns the character of the engagement.Seven of the investment positions yielded by the search (Martha Stewart,Heidrick & Struggles, Kmart, Sears, Krispy Kreme, Unisource, and Reynoldsand Reynolds) were cooperative upon initiation and retained that posture. Theyhave been left in the sample toward the end of minimizing ex post qualitativemanipulation.57 A strong argument nonetheless can be made for omitting Kmartand its subsequent acquisition, Sears. Edward Lampert and his ESL Partners
54. Specifically, Steel Partners II (9), Highfields Capital Management (6), Pirate Capital (6), ThirdPoint Management (6), ValueAct Capital (5), Barington Partners (5), JANA Partners (5), Carl Icahn &Co. (5), Newcastle Partners (4), Chapman Capital (4), K Capital (2), ESL Partners (2), Cannell Capital(2), MMI Investments (2), Appaloosa Management (2), Caxton Corp. (2), and Trian Partners (NelsonPeltz) (2), BP Capital Energy (Boone Pickens) (1), Relational Investors (1), Pershing Square (1), andTracinda Corp. (Kirk Kerkorian) (1).
55. John Dizard, Sovereign Dispute a Symbol of Something Bigger, FIN. TIMES (London), Feb. 7,2006, at 11.
56. See Farmer Bros. Co. (Schedule 13D) (Nov. 20, 2000) (filed by Franklin Mutual Advisers LLC);Phyllis Plitch, Efforts To End Dual-Class Share Structures Draw Votes, DOW JONES NEWSWIRES, May 24,2006 (describing activist intervention by Franklin and Morgan Stanley against dual class commoncapital structures).
57. Three cases of adverse activity, each involving attempts to open up closed-end investment companiesselling at a discount, have been omitted. Four other investments have been omitted as false positives: (1)ValueAct’s investment in MedQuist, because MedQuist has a 75% majority owner; (2) Cendant, reported as atarget of hedge fund complaints, because no fund has emerged either in a leadership role or in a 13D filing; (3)Morgan Stanley, despite the fact that hedge fund criticism was reported in connection with its recent CEOchange, because the complaining fund had a trivial stake in the firm and events in the firm can be moreplausibly ascribed to internal politics than external pressure; and (4) Albertsons, the subject of a successfulacquisition bid by a consortium led by the Cerberus Capital Management, because the transaction was friendly
1386 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
own a majority of the stock of the resulting firm—the only majority ownershipposition on the list. This ownership state erodes the line distinguishing hedgefund from private equity investment and is not the only case of such an overlapin recent years. Hedge funds have emerged as bidders in competition withprivate equity firms in auctions of companies seeking to go private, and thesecases have been excluded from the sample.58 The Kmart/Sears combination hasbeen retained due to its legendary status as a successful hedge fund interventionto change a business plan.59 The strategy has been widely copied by otherfunds, resulting in the appearance of a number of targets in the sample. Ataxonomic problem does remain and is dealt with by removing Kmart/Sears andthe other friendly investments from the sample as appropriate.
C. INVESTMENT POSITIONS
This Section looks at the investments made by the hedge funds in thetargets in the sample, breaking out aggregate figures by year of engagement,by the size of the target, and by the amount invested. The targets vary in sizefrom the smallest of fry (RedEnvelope, with a market capitalization of $7.4million) to the biggest of fish (Time Warner, with a market capitalization of$74.1 billion). Table I shows that, within the broad range, small firmsdominate the sample, making up 61% of the targets. This confirms theconventional wisdom that hedge funds concentrate their attention on thesmall capitalization sector.60 But, as already noted, the sample could nonethe-less understate their salience.
Table I: Target MarketCapitalization Number Percent Mean Median
Large Cap (over $5 billion) 15 13 $15.9 billion $11.2 billion
Mid Cap ($1 to $5 billion) 30 26 $2.5 billion $2.4 billion
Small Cap (under $1billion) 69 61 $281 million $172 million
and Cerberus had made no prior equity investment in the target. See generally Albertsons Will Be Sold for $9.7Billion, N.Y. TIMES, Jan. 24, 2006, at C2.
58. See Kishner & Foster, supra note 35, at 11. At the same time, private equity funds lately havebeen acting more like hedge funds. They are “flipping” their investments more quickly. BlackstoneGroup lately bought a 4.5% stake in Deutsche Telekom, paralleling the investment pattern of the hedgefunds. See Jason Singer, Raising the Stakes: In Twist for Private Buyouts, Some Shareholders FightBack, WALL ST. J., Aug. 18, 2006, at A1.
59. See generally Robert Berner, Eddie’s Master Stroke: The Sears-Kmart Merger Creates a RetailGiant, BUS. WK., Nov. 29, 2004, at 34 (explaining the details of the Kmart/Sears merger).
60. Market capitalization is calculated (by reference to the firm’s Form 10-K filed in the fiscal year endingprior to the first press report in the data sample) as follows: the average of the high and low stock prices for theyear’s last fiscal quarter multiplied by the number of shares outstanding at the end of the fiscal year.
2007] 1387HEDGE FUNDS AND GOVERNANCE TARGETS
According to another story, hedge fund activism will rise in waves, resem-bling the leveraged restructuring movement of the 1980s. One round of success-ful intervention will lead to larger targets in the next round. Success willencourage new activist entrants, leading to more firms being selected as targets.Table II roughly confirms this story of a rising tide. As the column for 2003shows, the tidal image comes more clearly into view if Kmart/Sears is omittedas a friendly anomaly. The level of activity reported in 2002 may come as asurprise. Activist intervention tends to be seen as a more recent phenomenon,but it turns out that hedge funds had been pushing managers for several yearsbefore the matter became the subject of policy discussions. Today’s strategiesadd nothing material to those followed five or more years ago.61 The tide, as itwere, already has risen.
Table II:Targets By Year 2002 2003 2004 2005
2006(six months)
Number 18 5 17 49 25
Mean target size (millions) $699 $3,307 ($496without
Kmart/Sears)
$702 $4,186 $5,138
Median target size (millions) $58 $895($473without
Kmart/Sears)
$201 $1,074 $841
Cost helps to explain the dominance of small capitalization targets, whilegrowing amounts of money under management help to explain the growth in thenumber of targets, particularly larger targets, over time. Larger targets call for asignificant increase in financial commitment: The engagement’s credibilityincreases with the percentage of voting shares held by, or allied with, theinitiating activist; the larger the target, the smaller the percentage of sharesbought by a set sum of money. Large numbers also make proxy contests moreexpensive. A credible threat accordingly presupposes a bigger fund. Unsurpris-ingly, then, the percentage of shares that a fund holds in a given target isnegatively correlated (�0.21) with the target’s market capitalization. What mostimpresses about this statistic, however, is less the negative result than its smallmagnitude. Restating, in the 39% of the cases involving large- or mid-capitalization firms, the hedge funds did not fully compensate for the largernumbers by reducing the proportion of outstanding shares purchased. Instead,
61. For examples of hedge fund strategies, see Steven Taub, Proxy Warriors, INSTITUTIONAL INVES-TOR, Jan. 2003, at 51. See also Steven Taub, Over the Hedge, DAILY DEAL, July 26, 2002 (noting theclaim of Herb Denton of Providence Capital to have mooted sixteen opposition board slates over fiveyears and placed twenty-two nominees on eleven boards).
1388 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
they stake materially greater sums. Table III breaks out median percentages ofshares held by target size (omitting Kmart/Sears) and the median investmentnecessary to create the holding (median market capitalization of large-, mid-and small-capitalization targets times the percentage of stock held). It turns outthat the larger targets implicate the lion’s share of the capital at risk.
Table III: Amounts InvestedMedian
Percent HeldMedian
Investment
Large Capitalization (Kmart/Sears omitted) 6.7 $753 million
Mid Capitalization 8 $194 million
Small Capitalization 9.8 $17 million
Why, assuming risk aversion even amongst hedge funds, do the large- andmid-capitalization engagements require these significant stakes of 6.7% and 8%of target stock? Figure I breaks down the funds’ shareholdings by percentagemagnitudes to show a notable clustering in the 5% to 10% range. Few attemptan engagement holding only 1% of the stock, presumably because it takes amore substantial block to pose a credible threat.
Federal regulation explains the break at 10%, the ownership level thattriggers the short swing profit disgorgement and reporting requirements ofsection 16 of the Securities Exchange Act of 1934.62 Many of the positionsbetween 10% and 20% follow from purchases made during the course of an
62. See 15 U.S.C. § 78p(a) (Supp. IV 2004); David Ikenberry & Josef Lakonishok, CorporateGovernance Through the Proxy Contest: Evidence and Implications, 66 J. BUS. 405, 413 (1993)
2007] 1389HEDGE FUNDS AND GOVERNANCE TARGETS
engagement, after the filing of an initial 13D reporting a smaller number ofshares. Such purchases signal an intent to hold on for at least six months. Thefive outliers with holdings above 20% all require specific explanation. Thelargest holding is Kmart/Sears (52.6%). Two others, Pizza Inn (32.5%) and SLIndustries (28.6%), are small, long-term holdings where the fund controls thetarget’s board of directors. The other two, Register.com and PW Eagle representgroups of funds filing joint SEC reports. At the other extreme lie seven caseswhere the fund holds less than 2% of the stock. This group is disparate and notdominated by large capitalization targets. Cases where an activist with a smallpercentage position takes a run at a large firm tend to fall in the 2% to 5% range.
D. TARGET CHARACTERISTICS
Hedge fund activism calls for a two-sided explanation. One side, as we haveseen, is institutional. We start with a large number of funds under pressure toproduce double digit returns even as more money pours in. This incentivizesfund managers to extend existing strategies and pursue new ones—thus have thevalue funds evolved into activists. They did so in a post-scandal environment63
with a slowly recovering stock market, an environment that makes otherinstitutional investors more inclined to be critical of managers, their strategies,and their governance practices. The other side of the explanation is financial. Asvalue investors, the activists look for firms worth more than their present marketprice. As activists, they are not content to sit back and wait for the rest of themarket to see the value and bid up the stock. They instead invest where theyjudge that their input by itself can cause the value to register.
There are three surprisingly easy ways an outside investor with influence candirect its input to get an immediate increase in return on investment. Theinvestor either (1) gets the target to sell itself at a premium to a second firm, (2)gets the target to sell or spin off a significant asset, or (3) gets the target to payout spare cash. There is also a fourth, more difficult way—the investor gets thetarget to change its long-term business plan for the better. The following looksat the set of targets through each of these four lenses.
1. Sale
In 33% (38) of the cases in the sample, the press reported the hedge fund’scontention that the target should be sold. It is easy to see why the activists makethis claim. In the U.S. merger market, companies are sold at a premium overmarket price that has averaged between 30 and 50% across the past threedecades.64 But some firms make better candidates for sale than do others.
(reporting on a sample of ninety-seven proxy contests conducted between 1968 and 1987, and findingthat the median challenger owned 10.6% of the stock). The hedge funds may be doing more with less.
63. See Shearer, supra note 15.64. William W. Bratton, The Disappearing Disciplinary Merger 31 (June 2006) (unpublished manu-
script, on file with author).
1390 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
Mergers occur in waves over time,65 and, within a given merger wave, activitytends to focus on specific industries. Activity within a given industry tends tocluster in a period of two or three years within a given wave,66 signallingdeal-making pressure.67 A management experiencing such pressure makes anattractive target. The hedge funds look for smaller, weaker, underleveragedfirms within a concentrated industry.68
The sample bears out these predictions. In a handful of cases, the target’smanagers themselves raised the red flag by cancelling a planned cash sale of thecompany (MaxWorldWide, Artesyn), or terminating a search process directed toa sale. In other cases, the company’s managers initiated a sale process, goingprivate process, or a private equity investment at a price deemed too low(Aspect Communications, Intercept, Bally, Stephan, Wells Financial, InfoUSA).
In still other cases, the activist looks for a firm amounting to a good prospect forsale in the market for going concern assets. The sample’s time period commencesduring a trough in that market that extended from late 2000 into 2003.
A new merger wave started thereafter. It has since risen steadily around anumber of focal point industries—energy, financial services, software and hightechnology products, commodity producers, health care, and real estate.69 Fig-ure II divides the target sample into business sectors. The sectors caught up inthe new merger wave are well represented, encompassing 49% of the targets. Inthese cases, the potential buyer is most likely a larger firm in the same industry.Private equity firms also are prominent buyers in the recent merger market,accounting for 14% of merger volume and focusing on smaller firms.70 Retailfirms, including specialty stores and restaurants, have figured prominently in theprivate equity purchase pattern.71 They, not coincidentally, make up the largesttarget category in the sample.
65. RICHARD A. BREALY & STEWART C. MYERS, PRINCIPLES OF CORPORATE FINANCE 997 (5th ed. 1996)(describing this trend as one of the great mysteries of financial economics).
66. See Mark I. Mitchell & J. Harold Mulherin, The Impact of Industry Shocks on Takeover andRestructuring Activity, 41 J. FIN. ECON. 193, 205 (1996).
67. For a confirming price study that shows that bidder returns are higher when the bid is lessanticipated, see Moon H. Song & Ralph A. Walkling, Anticipation, Acquisitions and Bidder Returns(Dice Center, Working Paper No. 2005-11, 2006), available at http://ssrn.com/abstract�698142.
68. See Brent Shearer, Shareholder Revolt Snaps into Deal-Killer Mode, MERGERS & ACQUISITIONS,Jan. 1, 2006. More particularly, a low ratio of enterprise value (EV) to earnings before interest, taxes,depreciation, and amortization (EBITDA) marks out a target. EV is market cap plus debt minuscash—the amount it would take to buy a firm and then pay off all of its obligations. EBITDA measurescash flows. A low ratio signals a company undervalued by the market with a good cash generatingcapacity. See Jack Hough, The Beauty of Ugly Stocks, SMARTMONEY, Nov. 1, 2005, at 47.
69. See Dennis K. Berman, Year-End Review of Markets & Finance 2005, WALL ST. J., Jan. 3, 2006,at R3; Dennis K. Berman, Year-End Review of Markets & Finance 2004, WALL ST. J., Jan. 3, 2005, atR10; Mark Cecil, First-Half M&A: A Review of the Sordid Truth, MERGERS & ACQUISITIONS REP., June30, 2003.
70. See Dennis K. Berman, Stock Market Quarterly Review: Private-Equity Firms Dominate M&ADeals; Sony-Led Group Pulls off MGM Win, As Corporations Mostly Stay Out of the Game, WALL ST.J., Oct. 1, 2004, at C13.
71. See Martin Sikora, A Diverse M&A Landscape, MERGERS & ACQUISITIONS, Feb. 2005, at 24.
2007] 1391HEDGE FUNDS AND GOVERNANCE TARGETS
Finally, recall the case of Mylan. Just as the sale of a firm means a premiumfor its stockholders, so does the transaction’s opposite party make the payment.If it pays too much, its stock falls. It follows that, as with Mylan, the announce-ment of an acquisition can be a red flag for activist intervention. Thus did fiveother firms on the list (Liquid Audio, Computer Horizons, Sovereign Bancorp,Spartan Stores, and Mirant) wake up to find themselves targets, and a sixth(Novt) attempt to escape a hedge fund challenge by making an acquisition onlyto have its shareholders vote down the deal.
2. Unbundling
Market intermediaries have been encouraging (or forcing) the unbundling ofconglomerate firms for a quarter century. In their view, conglomerate mergerssacrifice value, a view supported by a stack of studies.72 The rule of thumb putsthis “diversification discount” at 15%.73 According to the prevailing explana-tion, the value loss stems from the conglomerate firm’s ongoing overinvestment
72. See Raghuram Rajan, Henri Servaes & Luigi Zingales, The Diversification Discount andInefficient Investment, 55 J. FIN. 35, 36 (2000).
73. Philip G. Berger & Eli Ofek, Diversification’s Effect on Firm Value, 37 J. FIN. ECON. 39, 59–60(1995). See generally Henri Servaes, The Value of Diversification During the Conglomerate MergerWave, 51 J. FIN. 1201 (1996) (showing a loss in the 1960s and to a lesser extent in the 1970s).
1392 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
in the businesses of its unrelated subsidiaries74—the unrelated subsidiariesunderperform only to be subsidized by better performing divisions. Unbundling,whether through a direct sale of the unrelated assets or their “spin off” into aseparate publicly-traded firm, stops the flow of cash to poor performers. It alsoallows for better incentivized managers and imports transparency, facilitatingmonitoring by the board.75 Under an alternative line of explanation, the dis-count stems from defects in stock market pricing rather than agency costs andgovernance shortcomings. More particularly, the expected future returns ofdiversified firms are different from those of single purpose firms.76 The diversi-fied firms’ different expected returns dictate a higher discount rate. The “diversi-fication discount” follows from the use of a higher discount rate.
A hedge fund will appreciate a 15% discount without necessarily caring muchabout its source because unbundling the unrelated or underperforming asset canbe expected to increase the stock price. In 32% (36) of the cases in the sample,the hedge fund was reported at the outset as contending that the target shouldsell or spin off specified assets. Significantly, such a target need not be aconglomerate encompassing unrelated lines of business. A multidivisional firmin one industry can have an underperforming division that the others support, sothat the division’s sale or spin off will make up a discount. Indeed, the divisionneed not be a poor performer in order for the target’s stock to be discounted: ifan unessential division can be sold into the market for going concern assets at apremium unreflected in the ex ante stock price, the premium’s realizationenhances shareholder value (if not productivity). Thus do the activists look forfirms that recently have closed acquisitions within their own industries,77 readyto suggest that they sell their purchases and direct the proceeds into theshareholders’ pockets through a special dividend or share repurchase.78 Finally,targets can sell other assets, particularly unessential real estate. The activistshave pushed such sales at many targets in the retail and forest productsbusinesses—Kmart/Sears, Potlatch, McDonalds, Bally, Circuit City, OfficeMax,Weyerhaeuser, CKE, CBRL, and OSI. Note that real estate can be “unessential”even if the going concern still needs the premises situated thereon—the land can
74. See Philip G. Berger & Eli Ofek, Bustup Takeovers of Value-Destroying Diversified Firms, 51 J.FIN. 1175, 1176 (1996). See generally Rajan, Servaes & Zingales, supra note 72 (finding that internalcapital markets in conglomerates transfer funds across divisions in an inefficient manner in a Tobin’s qbased study).
75. Berger & Ofek, supra note 74, at 1176. In addition, the top team’s management skills may bebetter suited to the firm’s core assets than to the unrelated divisions. See Lane Daly, Vikas Mehrotra &Ranjini Sivakumar, Corporate Focus and Value Creation: Evidence from Spinoffs, 45 J. FIN. ECON. 257,259 (1997).
76. Owen A. Lamont & Christopher Polk, The Diversification Discount: Cash Flows Versus Returns,56 J. FIN. 1693, 1699–1705 (2001) (showing higher required returns for diversified firms).
77. See Taub, Proxy Warriors, supra note 61 (describing Jeffrey Ubben’s attraction to “roll ups”).78. See William W. Bratton, The New Dividend Puzzle, 93 GEO. L.J. 845, 849–52 (2005) (describing
payout practice).
2007] 1393HEDGE FUNDS AND GOVERNANCE TARGETS
be sold and leased back with the proceeds going out the shareholders.79 Withrecent real estate prices at an apparent cyclical high while stock prices havelanguished, the exercise makes perfect financial sense, at least from the point ofview of the shareholders.
3. Cash
With sale, whether of the whole or a part, the idea is to turn a going concerninvestment into present cash. It follows that the best of all targets is a firmsitting on a lot of cash already, or at least an amount in excess of the amountneeded to operate the business. Paying out such cash also makes perfectfinancial sense. Corporations tend to put such funds into safe short terminvestments; given the low interest rates prevailing today, such investmentsyield below the market return on the corporation’s stock.
Cash rich firms existed in record numbers in 2006. The cash accounts ofnonfinancial firms held a record $1.5 trillion, double the amount of seven yearsearlier.80 This amounted to 40% of the long-term debt of the firms in the S&P500, a ratio close to a record. Compared to their stock market value, the S&P500’s cash accounts stood at the highest point since the early 1980s.81 There area number of explanations. Firstly, the economy had been expanding and corpo-rate earnings had grown with it. At the same time, managers had not beenspending heavily on capital investment or raising their employees’ salaries.Indeed, shell-shocked by the 2001–2003 recession, they continued to cut operat-ing costs and to refinance in order to take advantage of low interest rates, bothof which enhanced cash yields.82 Although cash payouts to shareholders alsoincreased, they did not do so fast enough to deplete corporate holdings.83
There resulted a classic conflict of interest between the shareholder interest,on the one hand, and management and inside constituents, on the other. Holdingonto the cash enhances management’s freedom of action and insulates the firmfrom adverse economic shocks. To the shareholders, however, it is free cashflow—cash in excess of the businesses’ needs that ought to be paid out. Freecash flow was an issue two decades ago, when shareholders charged thatmanagers retained the cash to invest in suboptimal projects.84 Today the situa-tion is slightly different. Even as levels of cash match those of two decades ago,management cannot be accused of suboptimal reinvestment. Management has,to that extent, internalized the lessons of the 1980s. Instead, it simply holds the
79. See Sarah E. Lockyer, CKE Latest Target in Growing Trend of Activism, NATION’S RESTAURANT
NEWS, Feb. 29, 2006.80. Farzad, supra note 37, at 66.81. Shearer, supra note 15.82. Moreover, prior to 2005, firms were not using their spare cash as currency to make acquisitions.
See Ian McDonald, Awash in Cash: Cheap Money, Growing Risks, WALL ST. J., Nov. 28, 2005, at A1.83. Id. In 2005, the S&P 500 dividend yield was only 1.8%; sixty of the firms in the index reduced
their shares outstanding by 4% through repurchases. Id.84. Michael C. Jensen, Agency Costs, Free Cash Flow, Corporate Finance, and Takeovers, 76 AM.
ECON. REV. PAPERS & PROC. 323, 323–24 (1986).
1394 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
cash in short term investments. From a shareholder value point of view, this isan improvement, but not a cure. Meanwhile, the number of potential targetsgrows with the cash accounts.
Cash rich firms show up prominently in the sample. To test for cash, eightfirms were removed from the sample—the six banks and two investments indistressed firms (Adelphia and Footstar). Ratios of cash and cash equivalents tototal assets, and of cash and cash equivalents to short term borrowing andfunded debt85 were drawn from the remaining 107 firms’ balance sheets for thefiscal year preceding activist engagement. “Cash rich” is defined as a cash tototal assets ratio of 0.15 or greater plus a cash to debt ratio of 0.50 or greater. Bythis metric, 38% of the firms are cash rich. An additional 4% of the firms meetthe cash to debt leg of the test but not the cash to assets leg; one firm (Mirant)just misses both legs of the test.
The recent rise in corporate cash balances implies growing numbers of cashrich targets over time. Figure III, however, shows the opposite to have been thecase within the sample. The yearly percentage of cash rich targets stays stablefrom 2002 to 2004, ranging between 56% and 60%, and then declines to 31% in2005 and 22% in 2006. Median cash to debt ratios and cash to asset ratiosdecline similarly: cash to debt goes down from 7 in 2002 to 0.2 in 2006; mediancash to assets goes down from 0.2 in 2002 to 0.03 in 2006.
The results imply that the activists grabbed low-hanging fruit in the first threeyears, searching thereafter among a depleted stock of prime targets. Furtherextrapolation lets us predict an adverse selection problem. As more moneyflows into more funds pursuing double-digit gains from activist strategies, thefunds relax their financial standards, pursuing less appropriate targets. Extend-ing the projection one more step, fund returns decline, and the activist wave of
85. Including the current portion of funded debt.
2007] 1395HEDGE FUNDS AND GOVERNANCE TARGETS
2005–2006 subsides over time. The last projection implies a warning: Activistsgaining influence over the managers of firms holding out less immediate valuewill resort to high risk, high return strategies, replicating the pattern of the highleveraged restructurings of the late 1980s. The economy will be left to pick upthe deadweight cost of the resulting financial distress.
Such projections are easy to make. But nothing in the financial profiles of thefirms in the sample dictates that we do so. The sample’s early engagements didindeed include low hanging fruit. Several were firms that had raised cash in the1990s tech stock market only to find themselves with nowhere to invest it afterthe crash (Liquid Audio, MaxWorldWide, and MeVC Fund). It also is true thatlater targets have more debt and less cash. But the palette of value strategies hasbroadened. A lucrative real estate sale, for example, calls for no preexisting cashhorde. We will return to this matter in Part III when looking at the record ofcash payouts made by the target group.
4. Good Assets, Bad Managers
Activist engagements always start with a bill of particulars describing thetarget’s shortcomings. The bill, in turn, always starts by stating that the target’sstock is undervalued, perhaps also citing recent earnings reverses. The activist,as we have seen, then often recommends sale of the whole or a part ordisgorgement of uninvested cash. In many cases, however, the activist makes amore particular critique of the target’s managers and business plan. The usualallegation is excessive cost. With an energy firm, this means exploration costs.With a technology firm, this means research and development (R&D). Withother firms, this means selling, general, and administrative expenses (SG&A)—the costs of running the business (advertising, salaries, fringe benefits, andperquisites of the managers at headquarters) in addition to the costs of goodssold.86
These interventions raise questions respecting the activists’ standing as criticsand their allegations’ credibility. Making the allegation is not rocket science. Allone has to do is to take out the target’s income statement, highlight a cost line,check the comparables for lower numbers, and assert that the amount should belower. Executing a cost cutting program without impairing the firm’s productionfunction is another thing entirely. Doing so presupposes a significant investmentin knowledge of the business and a long-term investment commitment—properties historically more characteristic of private equity firms than hedgefunds. But many activists appear ready to make these commitments. Theyemploy industry experts to make diagnoses, they serve on their targets’ boards
86. According to one analyst, if the firm’s product does not require a large advertising budget,SG&A should be around 40% of gross profits; for a heavy advertiser, 60%; but if SG&A is 80%, costscan be cut. See Hough, supra note 68, at 47. In a few cases in the sample, the activists also highlightedright-side shortcomings—in particular new equity financing, whether through an issue of new commonstock or convertible debt. The reason is evident—new equity dilutes, depressing the stock’s value. Ifnew financing is necessary, the money should be borrowed, raising the rate of return on the stock.
1396 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
of directors, and, when they get into control positions, they employ experiencedmanagers to run the targets.87
The “good assets, bad managers” complaint extends to the targets’ gover-nance processes. Items on standard poor governance checklists show up promi-nently on activist bills of particulars—poison pills, staggered boards, lack ofdirector independence, and excessive stock options or other flawed incentivecompensation. The activists put these items at the front and center of theircomplaints. But, at the same time, there is no case in the sample in whichgovernance objections stand alone as the explanation for the intervention.Hedge fund activism is about value; governance and the processes of capitalmarket discipline take second place on the agenda. Governance and process alsoplay a tactical role. The credibility of an activist’s threat depends on itsplausibility within the wider community of institutional investors, and a show-ing of poor target governance practice enhances the case’s appeal.
E. TARGET PERFORMANCE
According to classic agency theory, problems of opportunism and adverseselection among managers generate “agency costs” that impair corporate perfor-mance.88 Two points follow. First, high agency cost firms will underperform inthe stock market relative to low agency cost firms. Second, governance interven-tion that reduces agency costs will improve performance and, thus, is justified.The theory triggers a question respecting the activist hedge funds and theirselection of targets: whether the targets underperform as compared to otherfirms in their industries or the stock market as a whole.
Significantly, nothing in agency theory dictates an affirmative reply in thiscase. Activists intervene because they see a chance to realize value in the nearfuture. Poor performance certainly can create such an opportunity, but so canpast success. A firm sitting on a large cash account may thereby have a lowreturn on equity and underperform relative to its peers, but cash by itself doesnot dictate that conclusion. Indeed, the cash may be there because the firm hasan outstanding management team that runs a tight ship. The same goes for atarget seen as a prospective acquisition candidate, or a target with saleableassets. When Pershing Square’s William Ackman took on McDonald’s in2005–2006 with an elaborate plan looking toward a sale of the real estateunderneath its company-owned franchises, he could not deny that the compa-ny’s CEO had just executed a brilliant turnaround.89 Similarly, the hedge fundsthat forced an auction of Beverly Enterprises acknowledged that managementhad done an excellent job and that its business plan remained plausible. But thefunds professed no interest in waiting around for the promised growth’s realiza-
87. See Kishner & Foster, supra note 35.88. Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency
Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976).89. See Authers, supra note 25, at 14.
2007] 1397HEDGE FUNDS AND GOVERNANCE TARGETS
tion.90 Success can make a firm like Beverly even more vulnerable to attack. Asits stock appreciates, long-term holders trade out and take their gains, leaving amore volatile, less satisfied stockholder population behind them.91
Nor need red flags of poor governance like poison pills and staggered boardsmean underperformance, even as they have been shown statistically to tend inthat direction.92 Consider Sovereign Bancorp, a firm in the sample that standsout for poor governance. Its imperial CEO, Jay Sidhu, triggered an activistchallenge by bringing in a friendly 20% blockholder and simultaneously usingthe proceeds of its equity investment to make a questionable acquisition.93 Theactivist had every reason to intervene, but past performance may not have beenone of them. Sovereign had outperformed its industry by 40% over the preced-ing three years, at least according to its 2005 proxy statement.94
Why should positive past performance matter if the activist can put value onthe table? To answer, let us draw on the team production theory of the firm.95
This suggests that value-creation in organizations presupposes a stable andcooperative environment. Outside attack impairs the environment, holding outcosts that need to be weighed against the benefits of short-term value-creationfor the shareholders’ benefit. The costs loom less large when the firm is a poorperformer—instability may even carry benefits in such a case. Where the firm isa good performer, instability not only may impair its performance, it also mayinhibit economic commitment at comparable firms.
Agency theory, then, suggests that poor performers make the most likelytargets, while team production theory suggests that they make the most appropri-ate targets. The SEC filings of the firms in the sample were consulted to see ifpoor performers predominate. The SEC requires reporting firms to report intheir annual proxy statements on their stocks’ performance against industry andmarket portfolios for the preceding five years.96 Reported figures were collectedfor 104 of the firms in the sample from the proxy statement immediatelypreceding the engagement’s onset (the remaining ten firms either failed tocomply, or failed to convene annual meetings). Figure IV sets out the percent-ages of underperforming firms in the sample, grouped by the year of theengagement’s commencement. A trend emerges—fewer underperformers show
90. See Phyllis Plitch, Companies Cut Deals To Sidestep Coup Attempts by Antsy Investors, WALL
ST. J., Aug. 10, 2005, at B3.91. See David A. Katz & Laura A. McIntosh, Advice on Coping with Hedge Fund Activism, 235
N.Y. L.J. 5 (2006).92. See Paul A. Gompers, Joy L. Ishii & Andrew Metrick, Corporate Governance and Equity Prices,
118 Q.J. ECON. 107, 121–25 (2003).93. See, e.g., John Dizard, Shareholders’ Blood is up over Sovereign and Calpine, FIN. TIMES
(London), Dec. 13, 2005, at 12.94. Sovereign Bancorp, Definitive Proxy Statement (Schedule 14A), at 38 (March 22, 2005).95. See, e.g., Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85
VA. L. REV. 247, 274–81 (1999) (describing a hierarchical governance structure suited to encouragingfirm-specific investment and team cooperation).
96. See Schedule 14A, item 8; Regulation S-K, item 402(l).
1398 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
up in the sample across time. The trend is particularly noticeable in the industryindex comparison—in the early years, four-fifths of the targets underperformedtheir industries; in the more recent three years, most of the targets were overperformers. The market yardstick also signals improvement in target quality,albeit less starkly.
The overall impression is one of a fifty-fifty split between underperformersand overperformers. To test this further, percentage measurements of underper-formance or overperformance were constructed for each firm’s stock priceagainst the industry index. Two classes of targets were removed from thesample at this point—the friendly engagements, in case of a skew either way,and two cases of investment in a distressed target (Adelphia and Footstar).Figure V shows median and mean results for (a) the entire sample, (b) by year:2002–2006, and (c) by size: large, mid, and small capitalization. The meanfigures are negative across the board, reflecting the presence of many extremecases in the underperforming group. The medians reflect the lesson of FigureIV—that the sample is roughly split between underperformers and overperform-ers, with the early years being more weighted toward underperformance. Amedian/mean comparison makes a third point—the over-performing companiescontain relatively few examples of notable success. Finally, a distinction can bedrawn between the large and mid capitalization firms and the small capitaliza-tion firms: The two subsets of larger targets are relatively free of catastrophicfailures, reflecting the basic financial point that larger firms hold out less risk.
2007] 1399HEDGE FUNDS AND GOVERNANCE TARGETS
Figure VI offers the same analysis of the targets’ performance against marketindices. The means once again show that large-magnitude outliers show up on thedownside. But the medians more clearly show the shift toward better performers after2003. They also confirm the separation between the small capitalization targets, on theone hand, and mid and large capitalization targets, on the other, with the former morepronounced in its selection of underperformers. The �140% mean result for thelarge-capitalization sector stems entirely from two targets—the long-lagging TimeWarner and just-out-of-Chapter 11 Mirant.
1400 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
Now to the question whether the data confirm or falsify the agency predictionthat activists will target underperforming firms. The proposition is neitherfalsified nor confirmed. On a per capita basis, neither type notably dominatesthe sample after 2003. At the same time, underperformance in the stock marketclearly attracts the activists. This outcome makes sense: Given equal value onoffer, a long-term failure makes a better target than does a reasonable performer,because the failure has a more dissatisfied group of shareholders.
Finally, note that empirical tests of takeover targets tend to show no system-atic underperformance by either industry or market measures.97 The comparisonis interesting. From both agency and team production points of view, the hedgefunds may be more discriminating in their target choice than are bidders in themarket for corporate control. Contrariwise, the large numbers of positive perform-ers in the group assure that many observers will see hedge fund activism asproblematic from a policy point of view.
F. SUMMARY
Activist hedge funds look for four things in their targets—potential sale ofthe whole, potential sale of a part, free cash, and cuttable costs. Given one ormore of those factors, poor performance makes for a better target. The sampleimplies some depletion in the stock of prime targets over time. But, as we alsohave seen, the number of interventions continues to increase. Given value onoffer, positive results do not assure repose in today’s boardrooms. Conversely,the bigger the target, the higher the level of difficulty and the greater thefinancial risk for the activist. But the deterrent effect of size has diminished overtime. Today, no board of directors is immune from challenge.
II. STRATEGIES, OUTCOMES, AND THE BALANCE OF POWER
This Part describes the record of engagement between the sample’s hedgefunds and targets. The salient strategic device is the proxy contest, whetherwaged in fact or merely threatened. The outcomes range between two clear-cutend points. On the win side lies sale of the target at a premium as the result ofthe intervention, while on the loss side lies hedge fund withdrawal withoutconcessions from the target. Between these termination points lie varying levelsof success. This success can come in the form of direct governance participationon the target board or indirect input through a back-and-forth process ofpressure and concession. Closer to the loss side lies continued managementresistance under pressure. Overall, the activists have had a high rate of success.
Section A describes the pattern of engagement, drawing on quantitativeresults from the sample. Section B sets out the governance outcomes of thecases in the sample.
97. See Bratton, supra note 64, at 5–12 (summarizing the studies).
2007] 1401HEDGE FUNDS AND GOVERNANCE TARGETS
A. PATTERNS OF ENGAGEMENT
The typical sequence of events can be divided into two stages. First comesinitial contact, when the activist reveals itself and the target decides whether tocooperate or resist. Resistance ushers in the second stage, during which theactivist pursues its strategy of attack. There are two possible outcomes: eitherthe activist gets what it wants, or it abandons the engagement and sells thestock. The latter result does not occur very often in the sample, however. Theactivists tend not to take no for an answer, and keep their campaigns going untilthey get a yes.
1. Initial Engagement
Engagements between activists and targets start with a letter and a follow-upcall, usually occurring just prior to the filing of a Schedule 13D that makespublic the fund’s ownership of 5% or more of the target’s stock. The letter (andthe call, if taken) tells the target that it is undervalued and outlines steps that thefund recommends to realize value for the shareholders in the near future. Thefund then asks for a meeting.
Target management has two choices at this point. It can take the call andconvene a meeting, looking toward a back-and-forth in which it defends itsbusiness plan and attempts to persuade the fund to take a passive, patient viewof its investment. Alternatively, it can refuse to engage; many targets have madethis choice. The immediate result of refusal is often a public rebuke in thefund’s first 13D filing. The rebuke will be addressed to the target shareholders,telling them that the fund has made constructive suggestions that the managershave ignored. Subsequent correspondence with the target likewise goes into theSEC file, which serves as the de facto press room in the fund’s campaign.Where, as with the cases in the sample here, the business press takes an interestin the matter, a new filing can prompt a new round of reports.
Consultants who market themselves as defensive advisors to managers cop-ing with activist interveners stress the initial stage’s importance. They recom-mend engagement with the goal of inducing more moderate responses. Theyalso recommend advance planning—managers should be ready with a persua-sive analysis that defends the business plan and, if possible, counters valueclaims made by the fund.98 The more effectively a target has communicated thecase for its business plan to the investment community prior to the engagement,the stronger the target’s position in the negotiation.99 Even better, say theconsultants, the firm should avoid being a target in the first place, anticipatingthe activists by remitting excess cash to the shareholders and actively monitor-ing and managing its mix of businesses.100 The consultants offer good advice.Even so, there is no case in the sample where an early meeting leads a hedge
98. See Katz & McIntosh, supra note 91, at 5.99. Preparing for and Pre-empting Hedge Fund Activism, INVESTMENT DEALERS’ DIG., May 29, 2006.100. Id.
1402 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
fund to abandon a publicized value maximization plan and accept the target’sexisting approach.101
By contrast, in 18% of the hostile cases, the engagement never gets past theinitial stage, with the fund’s public presence alone inducing target managementto make concessions. The wolf pack effect contributes to such decisions.102 The13D filing sends a signal to other funds who take positions in the target stock.103
The target sees little chance of victory in a contest fought to the finish and soeither comes to the table and settles or preemptively takes an action recom-mended by the activist. These initial stage concessions encompass a wide rangeof outcomes. On the minimal end, the concession implies no commitment—forexample, the target engages an investment banker to look into value-creatingalternatives or it appoints an additional independent director from the financialsector. More concrete initial stage concessions come in the form of asset salesand cash payouts. Even the ultimate concession—the sale of the company—occurred at the early stage when Knight-Ridder sold itself in 2006.104 In stillother cases, the target makes a process commitment to the activist’s agenda byconceding to it one or more seats on the board of directors. Thus did JeromeYork join the General Motors board as Kirk Kerkorian’s designee.105
2. Target Resistance, Hedge Fund Attack
In the more usual case, the target rejects the fund’s proposals, sometimes witha peremptory announcement and sometimes after a formal meeting. The activisttypically responds by threatening a proxy fight. The threat moves the engage-ment to the next stage. The activist has the choice of making good on the threatand incurring the expense of proxy solicitation, or of sitting back, keeping upthe pressure, and waiting for concessions. The latter route appears to bepreferred. Although a proxy contest at a small firm can cost as little as$100,000, the average cost ranges between $250,000 and $1 million.106
Meanwhile, the line separating a proxy threat from a proxy contest is not very
101. There are three cases in the friendly subset (Heidrick & Struggles, Unisource, and Reynoldsand Reynolds) where early meetings were held. However, there is no evidence that the meetings led tothe friendly stances.
102. Wolf pack behavior lends itself to the charge that the participating funds constitute a “group”for securities law purposes and hence should jointly file a 13D. The courts have not been receptive tothis claim, however. See Hallwood Realty Partners v. Gotham Partners, 286 F.3d 613, 616–18 (2d Cir.2002) (affirming district court’s finding that plaintiffs’ evidence of communication among three funds inquestion was insufficient to establish a group).
103. See Phyllis Plitch, Lawyers See No Poison Pill To Feed Hedge Fund “Wolf Packs,” DOW JONES
NEWSWIRES, Dec. 15, 2005 (describing wolf pack power and the absence of effective defenses); Katz &McIntosh, supra note 91, at 5 (stressing the importance of initial contact with the hedge fund).
104. For the result, see Knight Ridder Inc., Current Report (Form 8-K) (Mar. 14, 2006).105. See General Motors, Announcement of New Board Member (Form 8-K) (Feb. 6, 2006).106. See Marietta Cauchi, Activist Hedge Fund Strategy Gaining More Adherents, DOW JONES NEWS
SERVICE, Feb. 6, 2006.
2007] 1403HEDGE FUNDS AND GOVERNANCE TARGETS
clear under today’s liberalized SEC proxy rules.107 An activist that has “threat-ened” a proxy contest to no effect often follows up by announcing its “intent tosolicit” proxies. This raises the stakes, but not necessarily by much. Such anannouncement can occur nine or ten months prior to the annual meeting andimplies no commitment to proceed. It does entail a shift in the pattern of SECcompliance—correspondence, statements, and reports previously filed under13D now also go in as preliminary 14A solicitation materials. The filings, whichcan include outside expert analysis of the target and its business, get reported inthe press, and the pressure intensifies.108
Table IV: Proxy Contests (number of cases)
No threatof proxycontest
Threatwithout
initiation
Contest initiated(“intent to
solicit”)Extendedcampaigns
Boardelection via
proxy
Proxycontest
failsContestpending
24 17 60 13 19 7 2
The activist’s statement of intent to solicit, while manifestly made in the hopeof never getting to the point of filing and distributing a definitive proxystatement, nonetheless is credible. The activists, faced with a recalcitrant target,do make good on their threats and solicit. They also demonstrate their commit-ment and tenacity when defending managers resort to standard subterfuges likedelaying the annual meeting, increasing the number of directors, or amendingthe by-laws to impose new requirements on contestants. The funds go to courtin response—such litigation occurred in sixteen of the cases.
Activist tenacity is particularly evident in thirteen campaigns extending formore than one year. Typically, the fund accepts a minor concession, say, as inthe case of Topps, agreeing to hire an investment banker to look into valuealternatives. When this process leads to nothing, the fund proceeds with a proxyfight in a subsequent year. In the case of RedEnvelope, the campaign has beengoing on for three years, involving a proxy loss in 2004, a win along withmanagement concessions in 2005, and another pending contest in 2006. SantaMonica Partners, a persistent activist against Warwick Valley Telephone, lost anissue-based proxy solicitation but kept the campaign going anyway. The target
107. See 17 C.F.R. § 240.14a-12 (2006) (permitting communications prior to filing of proxy card solong as they are filed with the SEC and make specified disclosures). The activists also take advantage ofthe short slate provision, 17 C.F.R. § 240.14a-4(d) (2006), to run fewer candidates than the number ofseats up for election. For a discussion of the change in the regulatory environment, see Thomas W.Briggs, Corporate Governance and the New Hedge Fund Activism: An Empirical Analysis, 32 J. CORP.L. (forthcoming 2007) (manuscript at 7–13, on file with author), available at http://ssrn.com/abstract�911072.
108. There are also three “just vote no” cases and one meeting boycott to prevent the target fromgetting a quorum. One of these cases is pending (New York Times). None of the other three (StilwellFinancial, Houston Exploration, NABI Pharmaceuticals) managed to prevent the target from takingaction, but do not appear to have negatively impacted otherwise successful campaigns.
1404 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
made the concession of hiring an investment banker, but Santa Monica pushedharder and ran a board slate. It lost again, but does not appear to haveretreated.109
Once a proxy contest ripens into a bona fide solicitation, many targetmanagers settle after running a preliminary vote count and getting bad news.110
A small number of contests have gone to the count. The activists have garneredboard seats in nineteen of these. Management has won a solicitation in sevencases, two of them issue-based and five involving dissident board slates.111 Justlooking at the contests for board seats, this outcome means a 79% success rate.This figure compares with a 52% success rate derived by Ikenberry andLakonishok for a sample of ninety-seven board contests between 1968 and1987.112 By historical standards, then, the hedge funds are doing well.
An inquiry into subsequent events in the seven losing cases shows them to bedoing better still. In only one (Aspect Communications) did the fund acceptdefeat and withdraw. In another (Vista Bancorp), the target soon turned aroundand sold itself, fulfilling the activist’s objective. In a third (RedEnvelope), theactivist came back a year later to win a seat on the board. A two-time target(Warwick Valley Telephone) did at least hire an investment banker. The activistcampaign against it remains open, as it does respecting the two remainingtargets in this group (InfoUSA and Astoria Financial), making the final out-comes uncertain. Results in “initiated” proxy contests also are pending inanother two cases.
B. OUTCOMES
Table V sets out results respecting the targets in the hostile sample, as of December31, 2006. Each case is assigned one outcome; for cases involving ongoing campaignswith multiple results over time, the figures reflect the most recent event in the case.Table V arranges the outcomes to highlight the cases’ process characteristics, breakingout three categories—settlement, pressure, and full-dress proxy contest. A “settle-ment” implies an arrangement concluded as the result of negotiations between theactivist and the target. These tend to accompany the initiation of a proxy fight.Concessions resulting from “pressure,” in contrast, do not stem from face-to-faceagreements and often occur as the target’s unilateral action, at least when viewed fromoutside. Together these cases make up 67% of the sample and 80% of the group of
109. See Chris Nolter, Rural Telecoms Draw Hedge Funds, THEDEAL.COM, July 3, 2006.110. This happened in ten of the sixteen full-blown contests (whether or not involving hedge fund
proponents) that occurred in 2005. See Plitch, supra note 90.111. Institutional Shareholder Services often recommends votes for the dissident slate (for example,
Exar and Nautica) but also has sided with management in other cases (for example, MeVC, WarwickValley Telephone, Aspect). For a compilation of ISS advice respecting proxy contests between hedgefunds and targets, see Briggs, supra note 107, at A-1 to -3.
112. See Ikenberry & Lakonishok, supra note 62, at 413–14. Too much should not be made of thecomparison of success rates, however. The Ikenberry and Lakonishok numbers date from the era beforethe proxy rules facilitated nonmanagement solicitations for fewer than all seats up for election; the levelof difficulty was correspondingly higher.
2007] 1405HEDGE FUNDS AND GOVERNANCE TARGETS
successes. The class of proxy contest victories makes up 17% of the sample and 20%of the successful group.
Table V: Outcomes (percent of the hostile sample)
Successful Outcomes: 84 %
Settlement:Boardseat
Settlement:No Board
seat
Pressure:Major
concession
Pressure:Minor
concession
ProxyContest:
Board seat
23 7 24 13 17
Other Outcomes: 16%
Proxycontestpending
Pressurefails:
withdrawal
Proxyfails:
withdrawalOtherfailure
Outcomeopen
2 2 1 2 9
“Success” is defined capaciously to include any cognizable target concession.Cash payouts bring the target into the success category in 29% of the hostilecases. Other indicia of success include board membership (40% of the hostiletargets), sale or liquidation of the target (28%), and the sale or the sale or spinoff of a division (21%).113 “Success” also includes minor concessions likeinvestment banker engagement and governance overhauls.
The “success” classification entails a judgment call in one case, WilliamAckman’s run at McDonald’s in late 2005. McDonald’s, rejecting his proposal,threw out a bone in the form of real estate sales abroad. Ackman withdrew,declaring victory, though at least one industry analyst suspected that Mc-Donald’s had been working on the foreign real estate sales long before Ack-man’s appearance.114 Ackman has been given the benefit of the doubt, with thecase being categorized as one of “pressure: minor concession.” But the failurecharacterization also fits. Indeed, Ackman’s campaign transgressed two ofactivist Robert Chapman’s “tenets of activism”: first, avoid “weight-size mis-matches”—here the target’s size unduly raised the hurdle to forcing the issuewith a proxy fight; and, second, avoid “credible incumbents”115—here the targetCEO’s successful turnaround record lent credibility to the substantive rebuttal.Carl Icahn’s attack on Time Warner presents another such case. Time Warner, aperennial burner of shareholder value, would appear to make an excellent target.Icahn invested in a serious substantive presentation, commissioning an elabo-rate restructuring plan from a blue chip investment banker. Wall Street neverthe-less favored the company’s CEO, Richard Parsons, and questioned Icahn’s plan
113. Companies may overlap in the results for sale, asset sale, and cash payout.114. See Dane Hamilton, Hedge Fund Drops Campaign Against McDonald’s, REUTERS NEWS, Jan. 5,
2006.115. Christopher Faille, How (Not) To Be an Investor Activist: Object Lessons, HEDGEWORLD DAILY
NEWS, Mar. 6, 2006.
1406 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
on the merits. Icahn peremptorily dropped the campaign. The case nonethelesseasily qualifies as a success under the standard here because Time Warnerresponded with a $5-billion share buyback announcement, raising the amount to$20 billion during the back-and-forth with Icahn.116
Table VI focuses on the large and mid capitalization firms in the subset ofsuccessful engagements. These targets emerge with a distinct profile within thegroup, reflecting the higher degree of difficulty and echoing Chapman’s warningabout weight to size mismatches. These targets show up in the successful subsetin the same proportion as in the sample as a whole—they make up 39% of both.But, within the success subset, they tend to be underrepresented within theboard seat category, most notably in the full dress proxy contests. Making up forthis, they are overrepresented in the “pressure” category. Pressure withoutproxies makes cost/benefit sense for the activist: The bigger the target, the moreexpensive the proxy contest, but the greater the publicity generated by theactivist campaign. The numbers showing that larger targets predominate in thecash payout and asset sale groups permit some inferences about the preferencesof the larger targets’ managers: Concrete economic concessions dominate overpower sharing through board membership. The managers are not necessarilygiving away the store in so doing—Part III will show that relatively modestamounts of cash are being paid out and many payouts are funded with theproceeds of asset sales.
Table VI: Large and Mid Capitalization Targets (percent of the successfuloutcomes)
Entiresuccessful
sample
Settle-ment:Boardseat
Settle-ment:
Noboardseat
Pressure:Major
concession
Pressure:Minor
concession
ProxyContest:
Board seatTargetsold
Cashpayout
Assetsold
39 28 48 58 57 17 33 58 45
The pattern of activist demand and target response amounts to a strategiclearning process, with both sides asking the same question: How much will ittake to make the activists go away? That question has not yet been answered inmany of these cases. Activist successes amount to closed cases only in 28% inwhich the target has agreed to be sold and in the 11% in which the activist has
116. See Bernard Condon, Buyback Boomlet, FORBES, May 22, 2006. General Motors is another casewarranting special mention. It easily fits the success category due to concession of a board seat underpressure. But the activist, Kirk Kerkorian, and his board designee, Jerome York, lost their enthusiasmfor the engagement when the CEO and the board proved unreceptive to their suggested business plan.York resigned; Kerkorian sold out. See Warren Brown, The Gambler Cashes Out, Ready for AnotherGame, WASH. POST, Dec. 10, 2006, at G2.
2007] 1407HEDGE FUNDS AND GOVERNANCE TARGETS
taken control of the board of directors. In the majority of the cases where thefund has a minority stake on the board or continues to hold the stock after apartial concession, disagreement between target and activist remains a possibil-ity. At the same time, an implicit commitment toward cooperative resolution ofdisputes obtains in the 40% of hostile cases in which the activist has gainedboard representation.
Most of the “other” outcomes set out in Table V are ongoing engagements yetto be determined. These undecideds are broken into two groups. In one group aproxy contest is proceeding or said to be in the works (2% of the sample) and inthe other the hedge fund and the pressure remain (9%), awaiting a concession.
Finally, we move to “failure”—defined as the hedge fund’s failure to accom-plish any of its governance objectives before terminating the engagement. Thiscategory, which includes only 5% of the sample, also includes a close case,Mellon Financial. There, Highfields Capital showed up in 2005 holding 2.12%of the stock and demanding a split up. Mellon refused, and began purchasingassets. Highfields then sold 3.8 million of its 9 million shares,117 signalingretreat. But, with Relational Investors also holding a block of stock, Mellonfaced a continuing threat. Mellon itself finally terminated the engagement inDecember 2006 when it agreed to merge with the Bank of New York in amerger of equals, a deal that accorded a (small) premium only to the Bank ofNew York shareholders.118 In another case in the failure category, Penn Vir-ginia, the governance failure appears to stem from the investment’s financialsuccess. Boone Pickens started this campaign in 2002, putting an offer topurchase on the table and leaving it there for ten months to no effect. Pickenssold down to under 5% of the stock before the end of that year and has not beenheard from since at Penn Virginia.119 Third Point Management, which alreadyhad taken a position in the stock, followed up in 2003, demanding a place on theboard and threatening a proxy fight. The board refused the seat; Third Point didnot initiate the fight, and subsequently sold down its holding the followingyear.120 If that were the entire story, the case would be anomalous, tenacitybeing a consistent activist attribute. But Third Point was close to having tripledits two-year investment when it sold, financial reality apparently trumping itsgovernance agenda. Profit also accompanied the hedge fund’s unwind in a thirdfailure, Aspect Communications, one of the few lost proxy contests.121
The other three failures violate Robert Chapman’s other two activist tenets:
117. Compare Highfields Capital Management LP (Form 13F-HR) (Nov. 14, 2005), with HighfieldsCapital Management LP (Form 13F-HR) (Feb. 14, 2006).
118. See Vipal Monga & Peter Moreira, BoNY and Mellon Combine, THEDEAL.COM, Dec. 5, 2006.119. For the last evidence of Pickens in the SEC file, see Penn Virginia Corp. (Schedule 13D/A)
(Sept. 18, 2002) (filed by BP Capital Energy Equity Fund LP) (showing 6.5% ownership).120. Penn Virginia Corp. (Schedule 13D/A) (June 17, 2004) (filed by Third Point Management Co.
LLC) (selling below 5%).121. The hedge fund went in at $2.15 to $3.44. See Aspect Communications Corp. (Schedule 13D)
(Dec. 30, 2002) (filed by Scepter Holdings Inc.). The time of exit is not clear, but the stock could nothave been lower than $7.37 during the period in question.
1408 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
no “poison prey”—the stock has to qualify as a good long-term hold on apassive basis; and no Pyrrhic victories—the stock must have potential to go upafter a concession.122 In one case, Third Point went into a troubled firm, SaltonInc., at $6 per share in September 2004. Third Point had ideas about itsrestructuring.123 It went out in April 2005 at $1.25 to $1.60, with nothingreported as having occurred during the interim.124 Two other troubled firms,Adelphia and Footstar complete the set. The former went into bankruptcybefore the engagement had a chance to develop, and the latter looked to sale ofthe target as a stalling device. The hedge fund sold at a slight profit, beforemanagement decided to go into the Chapter.125
C. SUMMARY
The activists have an impressive record of success in the cases in thesample—so impressive that the record supports the proposition that they haveshifted the balance of corporate power in the direction of outside shareholdersand their financial agendas. But the proposition, once mooted, only triggersmore questions. The leading question is whether this activist sector will con-tinue to grow and become a permanent feature of the corporate landscape. If itdoes, it could occasion a modification of the prevailing description of a separa-tion of ownership and control between shareholders and managers. Answeringthat question requires prognostication well beyond the scope of this Article,calling for projections respecting flows of investment capital into hedge fundsand of the future relationship between corporate asset values and stock marketcapitalizations. If the flow of capital to the funds slows and market pricesrecover and match or exceed corporate asset values, hedge fund activists mayfade in the manner of their cyclical predecessors, the legendary corporateraiders of the 1950s and 1980s.126
The sample can, however, assist in addressing other, lesser questions. Thefirst is whether the hedge funds cause harm, draining productive enterprises ofcapital and molesting business plans and capital structures in search of short-term profits. The second concerns the amount of those profits. Part III takes upthese matters.
III. FINANCIAL OUTCOMES
This Part uncovers the light the sample sheds on four questions. The first,taken up in Section A, is whether the activists are short-term investors whoextract cash and exit immediately. The answer is a clear no in all but a small
122. Faille, supra note 115.123. Salton Inc. (Schedule 13D) (Sept. 20, 2004) (filed by Third Point Management Co. LLC).124. Salton Inc. (Schedule 13D) (Apr. 27, 2005) (filed by Third Point LLC) (selling below 5%).125. See Footstar Inc. (Schedule 13D) (Jan. 15, 2004) (filed by Chap Cap Partners LP).126. See Schurr, supra note 19, at 19 (discussing the cyclical nature of “activist onslaughts,” which
typically arrive after decades of relative market inactivity).
2007] 1409HEDGE FUNDS AND GOVERNANCE TARGETS
number of cases. But the answer is less clear respecting the follow-up questionof whether the activists are long-term investors. It is simply too soon in thehistory of hedge fund activist engagement for an answer to be forthcoming. Thesecond question, taken up in Section B, is whether brutal cost cutting accompa-nies hedge fund intervention. The answer is no, subject to some exceptions. Thethird question, taken up in Section C, is whether the activists are bringing backthe high-leveraged restructuring of the 1980s, forcing firms to borrow to financelarge cash payouts and leaving them with unsustainable capital structures. Herethe answer again is a clear no in all but one case. The fourth question, taken upin Section D, is whether activism has yielded windfall profits that can beexpected to lure ever-increasing numbers of reckless, inexperienced players.Here the answer is a more equivocal no.
A. DURATION
Hedge funds are said to invest short term, and short-term investment is saidto be a bad thing. But why should that be? We like to tell ourselves in thiscountry that ours are the world’s best capital markets because they offerexceptional liquidity and liquidity means a lower cost of equity capital.127 Thismarket advantage is precisely what makes short-term investment possible.Investors have taken full advantage. Average annual share turnover for firmslisted on the New York Stock Exchange was 12% in 1960. It rose to 73% in theheated market of 1987,128 fell back thereafter, and then rose again to 82% in theheated market of 1999.129 For companies listed on the NASDAQ in 1999,annual turnover was three times higher—Amazon’s stock turned over everyseven days that year.130 But such churning, considered in isolation, presents aproblem only for the investors who engage in it.
Short-term investors do become a problem when they influence managementdecisions. In the classic example, a manager who, left in isolation, would makea long-term investment that maximizes the value of the firm, foregoes theinvestment in order to boost accounting earnings in the near term and therebymaintain good relationships with the shareholders. Alternatively, the managermakes aggressive accounting decisions that improve earnings per share, only tostumble into destabilizing compliance problems.131 The appearance of institu-tional investors in the dominant shareholding role complicates this problemwithout solving it. Different institutional holders have different investment
127. See Erik Berglof, Reforming Corporate Governance: Redirecting the European Agenda, ECON.POL’Y 93, 113 (1997).
128. See Kenneth Froot, Andre F. Perold & Jeremy C. Stein, Shareholder Trading Practices andCorporate Investment Horizons, 5 J. APPLIED CORP. FIN. 42, 42 (1992).
129. John A. Byrne, When Capital Gets Antsy, BUS. WK., Sept. 13, 1999, at 72–76.130. Id.131. The heated markets of the late 1990s proved conducive to both situations. See Joseph Fuller &
Michael C. Jensen, Just Say No to Wall Street, 14 J. APPLIED CORP. FIN. 41, 42–43 (2002).
1410 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
styles, and many look primarily to near-term returns.132 Equity incentive payschemes also complicate the problem without solving it because they omitconstraints on disposition that would force their manager-beneficiaries to along-term view.133 Long-term investors have not completely disappeared, how-ever. The stock of blue chips like General Electric and Proctor & Gamble tookmore than two years to turn over even in 1999.134 Managers seek out theselong-term shareholders.135 Value investors usually are seen as a subset of thegroup.
The hedge funds present a potential problem despite their roots in the valueinvestor segment. Their institutional structures put them in an intermediate timecategory,136 while performance pressures keep them focused on near-term gain.Accordingly, an activist could initiate a campaign with a view to getting aconcession that appeals to the short-term shareholder interest and sell into therising market that greets the concession. A cash payout or cost cutting restructur-ing that has this effect could meet the activist’s objective even though itsacrifices long-term value.
The activists’ time horizons accordingly bear on the question whether theirinterventions amount to a beneficial or detrimental application of capital marketdiscipline. The sample provides a window through which to view their holdingpatterns. More particularly, the targets’ and funds’ SEC files have been reviewedto see whether the fund initiating each engagement retained at least 5% of thetarget’s stock through December 31, 2006. Figure VII presents the results forthe entire sample and a subsample comprised of engagements commencedbefore June 30, 2005. In the full sample, the fund is still there in 54% of thecases.137 In another 27%, the target either has been sold or gone bankrupt,effectively terminating all-equity participations. The “split term” category (5%)picks up cases where either (a) the fund sold a substantial part of its holding butstill retains a substantial investment, or (b) a second fund joined the engagementand stayed on after the lead fund disinvested. “Sold” means what it says, andcovers 12% of the targets. The label is assigned where the fund files a Schedule
132. See Brian J. Bushee, Do Institutional Investors Prefer Near-Term Earnings Over Long-RunValue 30 (Apr. 1999) (unpublished manuscript, on file with author), available at http://ssrn.com/abstract � 161739 (finding empirically that institutions overall have a weak preference for short-termearnings).
133. See William W. Bratton, Supersize Pay, Incentive Compatibility and the Volatile ShareholderInterest, 1 VA. L. & BUS. REV. 55, 73–76 (2006) (discussing the negative effects that stock options,restricted stock, and other equity incentive payment schemes have on creation of long-term fundamen-tal value).
134. Byrne, supra note 129, at 72–73 (noting that Proctor & Gamble’s average investment time was25.1 months, while General Electric’s was 33.1 months).
135. Toward that end, they have increased time spent on investor relations. Id. at 72–76 (discussingthe increased and differentiated efforts of managers to attract long-term investors).
136. See supra text accompanying note 45.137. Still there in that it owns 5% of the stock, or, in the few cases where the fund never amassed a
5% holding, evidence exists from the press or an SEC 13F filing supporting the inference that itremained on June 30, 2006.
2007] 1411HEDGE FUNDS AND GOVERNANCE TARGETS
13D reporting that it owns less than 5% of the stock and there is no subsequentevidence that it retains a substantial interest in the target. The sold targets areclumped in the sample’s early years: eight of the fourteen sold engagementscommenced between 2002 and 2004. Despite this, sold positions comprise only18% of the early subsample.
Let us now apply this evidence to make the best case for the activists: In animpressive 81% of the cases in the full sample and 77% in the early subsample,they either have retained a substantial investment in the target or taken a payouton a pro rata basis with the target’s other shareholders upon the sale of thecompany. Additional data bolsters the point. When an activist gains a seat on theboard, it has a choice as to how to fill it. It may send one of its own principals,thereby constraining its trading ability due to an insider position, or it can send adesignee and preserve some trading flexibility.138 A review of the sample toascertain the identities of the activists’ nominees reveals the following: Fundprincipals have joined the board (along with designees in some cases of morethan one seat) in thirty-five cases, while a designee has been dispatched in eightcases. The practice, then, lies on the side of a time commitment.
We also need to take a look at the cases where the activist sold its shares.Four of these targets were held for two years or more, another five for one totwo years, and eight for less than one year. We have already encountered threeof them (Aspect, Penn Virginia, and Salton) above amongst the governancefailures. Another two (Martha Stewart and Heidrick & Struggles) were friendlyinvestments. In two other cases (OfficeMax and PRG-Schultz), the fund ex-tracted minor concessions and then sold into a falling market. Two cases(Unisource Energy and General Motors) saw an engagement of 11 months
138. See Barreto, supra note 53 (“[O]nce a manager joins the board[,] trading of the company’sshares owned by the hedge fund would be restricted because of insider trading rules.”).
1412 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
followed by an early exit at a slight profit. Things went better at five other casesin which the exit sales yielded substantial profits. In one of the five (MSCSoftware) the hedge fund first scored a settlement that provided board seats. Itthen reversed itself, unwound its settlement agreement and withdrew from theboard to exit at the end of a year at a substantial profit. In another (SteveMadden), the target conceded only the appointment of an additional outsidedirector, with the hedge fund holding for two years before taking its profit.
This leaves three cases. Here we finally do get a suggestion of opportunism.Carl Icahn was the activist in two of the three: Mylan Laboratories, described inthe Introduction, and Temple-Inland. Icahn followed the same playbook withboth—first, threaten and initiate a proxy contest, next get target to disgorgesignificant cash, and then quickly sell. The extraction of significant concessionsin both cases removes any suggestion of misconduct—the payouts were sharedpro rata with the other shareholders; neither case was a pump and dump inwhich Icahn sold the shares into a market buoyed solely by the news of hisstake in the target. In fact, Icahn reversed course and reinvested in Temple-Inland soon after selling the stock. Only the last case, Gyrodyne, presents aclassic abuse story; the abuse was greenmail. Pursuant to a settlement, KCapital sold its part of its holding back to issuer at a premium and the rest intothe market.139 Significantly, K Capital was a short-termer in its other appear-ance in the sample, OfficeMax.
In sum, the activists’ holding record, while not pristine, shows that mostcommit to their targets for at least the intermediate term. It is too soon to knowhow many of these commitments will endure into the long term. Meanwhile, theevidence, taken as a whole, does not sustain the claims of the activists’detractors.
B. COST CUTTING
Recall that activists often complain of excess costs, usually as to SG&A,R&D, or executive pay. In one famous case in the sample, BKF Capital Group,successful activists followed through with cuts only to face unexpected negativeresults. Steel Partners II (owning 8.7%), in tandem with Carl Icahn & Co.(owning 14.3%), and Cannell Capital (owning 9.4%),140 took three board seatsat BKF after a proxy fight in 2005, with Steel’s Warren Lichtenstein taking theboard chairmanship. The group had fought and won on the ground that the firmpaid excessive bonuses to its managers, including its founder and CEO, John A.Levin. When the new regime came in wielding its shareholder value costclippers, Levin and most of the portfolio managers declined the haircut, resign-ing and taking the lion’s share of the funds under management with them. The
139. See Gyrodyne Co. of America Inc. (Schedule 13D/A) (Apr. 17, 2002) (filed by K CapitalPartners LLC).
140. See BKF Capital Group Inc., Definitive Proxy Statement (Schedule 14A), at 13 (May 26,2006).
2007] 1413HEDGE FUNDS AND GOVERNANCE TARGETS
firm has not since recovered, and Lichtenstein has withdrawn as chair.141 Thestory has three morals: First, it warns us that successful activists can do harm.Here they took the out clippers at a firm built on personal relationships,142
apparently without pausing to ask about their management targets’ job mobility.Second, the time commitment implied by an activist’s presence on the board canbe fragile. Third, when activists behave in ways calculated to advance theirdetractors’ case, Carl Icahn never seems to be far away.
Meanwhile, a question arises respecting the activists’ impact on cost levels atthe other targets. To illustrate this, a subsample has been broken out, made up offirms in which the engagement began prior to 2006 and the activist retained itsinvestment position on June 30, 2006. Ratios of SG&A to revenues and R&D torevenues were constructed from the firms’ annual reports for three years beforethe engagement and all years since the engagement’s commencement to the endof 2006. Ratios of cash bonuses paid to the firms’ top executives (and reportedin the annual proxy statement) to net income also were constructed, on the samebefore and after basis. A single before and after ratio was derived for each firmby averaging figures across multiple years. The firms were then divided into twoclasses, depending on whether a hedge fund representative had joined the boardof directors.
Figure VIII reports the median and mean results. SG&A is the cost thatrepresents the largest cash outflow for the firms by far. The SG&A to revenuesratio has risen in both subsets on both a mean and a median basis, indicatingthat no significant cost cutting occurred. It has gone differently with R&D, anexpense incurred in only thirteen of the fifty-two firms. Mean R&D to revenues
141. See BKF Capital Group Inc. (Form 8-K) (Apr. 26, 2006).142. See Joe Nocera, No Victors, Few Spoils in this Fight, N.Y. TIMES, July 22, 2006, at C1; see also
Jenny Anderson, When Winning the Battle Leads to Losing the War, N.Y. TIMES, Oct. 28, 2005, at C7.
1414 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
ratios dropped in both subsets, with a negative median result for the boardrepresentation firms and a slight increase for the others. But no inference ofhedge fund causation can be drawn from the negative figures. In four of thefirms with lower R&D ratios, management already had been cutting aggres-sively in the years before the hedge fund’s arrival. Moreover, R&D expendi-tures actually went up in another seven of the thirteen firms; the negative ratiosderive from the fact that the expenditures did not go up as much as revenues.The cash bonus medians are 0% and -2%, showing no tendency toward cuts.The bonus means signal substantial raises in executive pay. The group of firmsthat increased their bonus pool includes BKF Capital, which had to hire a newCEO.
The sample, then, does not suggest strong hedge fund impact on SG&A,R&D, and executive bonuses. Although there may have been some slashing andburning, its magnitude has been insufficient to skew the aggregate figures. Thisresult is tentative, however. With time and boardroom influence, the activistsmay have more of an impact; in addition, a comparison with same-industrycontrol firms might show an impact.
C. CASH PAYOUTS AND BORROWING
BKF is the only case in the sample where hedge fund interventionrespecting a business plan has had manifestly adverse effects. But hedgefunds also intervene on the financial side, pressuring firms to disgorgecash—either by substantially increasing a regular dividend, paying a specialdividend, or repurchasing stock. Such payouts potentially weaken the targetsby depriving their managers of ready capital to finance new projects.Whether this leads a target to forego a good project depends on theavailability of alternate sources of finance, particularly debt capital. Such aconstraint is most likely to result where a firm already is highly levered, orwhere, as with the high leverage restructurings of the 1980s, the firmborrows a substantial sum to finance the shareholder payout.
The financial statements of all targets were reviewed to isolate the firmsmaking cash payouts to shareholders exceeding the level maintained prior tothe commencement of activist engagement. A subset of forty-one firmsemerged.143 Table VII displays aggregate amounts paid before December 31,2006 (or amounts to be paid in the case of firms that have announcedspecific payouts but have not yet effectuated them). The amounts correlatepositively and proportionately with firm size—there is a 95% positivecorrelation between market capitalization and the firm’s payment. But thepayout subsample also contains a notable skew toward larger targets. Themedian market capitalization of the entire sample is $539 million, while for
143. Payouts have been announced by an additional two targets: California Coastal and Mirant, theformer stating an intent to finance through borrowing and the latter through cash on hand and an assetsale.
2007] 1415HEDGE FUNDS AND GOVERNANCE TARGETS
payout firms it is $1.829 billion. The percentage comparisons in Table VIIexpand on this point. Whereas large- and mid-capitalization firms make up39% of the entire sample and only 21% of the cash-rich firms, they make up56% of the payout firms.
Table VII: Cash Payouts by Targets
MedianAmount Paid($ million)
MeanAmount Paid($ million)
Percent ofPayoutSample
Percent ofEntire Sample
Percent ofCash-Rich
Targets
Large Cap 1,450 2,776 20 13 3
Mid Cap 619 590 36 26 15
Small Cap 26 65 44 61 82
The disproportionate appearance of large firms makes sense—firms thatmake regular dividends and periodically repurchase shares come from large-and mid-capitalization sectors in the first place.144 Now add a fact—puttingaside one friendly case in the payout group (Sears)—82% of the large- andmid- capitalization firms making payments did so as a reaction to pressure; arelatively low 18% of these firms surrendered board seats. This confirms apoint made earlier; larger firms that can afford it use their cash to buy off theactivists and return to normalcy. This coin also has another side; when alarge target has cash, the activist will manage to extract some of it. Of thelarge- and mid-sized firms that were cash-rich prior to the engagement, allshow up in the payout group except three: Kmart, which used its cash to buySears; Siebel Systems, which was sold; and Earthlink, as to which anoutcome remains pending.
Parallel observations can be made respecting the small capitalization firms inthe payout subsample. Just as larger firms that are more able to pay dominatethe subsample as a whole, firms with a notable ability to pay dominate thesubsample’s subset of small firms: 61% of the smaller firms in the payout groupwere cash rich ex ante.
We turn now to the payments and modes of funding. Sixteen of the firmsin the subsample were cash rich ex ante—cash later depleted by activistinduced payouts. Based on a review of the firms’ cash flow statements, itappears that the ex ante cash afforded the exclusive source of paid out fundsat ten firms, comprising 24% of the payout group. Carrying on the patterndistinguishing the larger and smaller firms, eight of the ten were in the smallcapitalization subset.
The remaining firms, whatever their size, looked to other means to finance
144. See Eugene F. Fama & Kenneth R. French, Disappearing Dividends: Changing Firm Character-istics or Lower Propensity to Pay?, 60 J. FIN. ECON. 3, 19 (2001).
The subsample also contains seven firms (17% of the subsample) that overlap with the small set offirms (12% of the whole sample) in which the activist sold out. This at least suggests that a hedge fundthat extracts cash is more likely to disengage and go on to something else.
1416 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
their payouts (or, in the case of six remaining cash-rich firms in the subsample,additional means). They had a choice of three—they either could borrow, sell anasset for cash, or rely on future periodic cash flows. Within the subsample,based on a review of the firms’ cash flow statements, asset sale has been theleading choice—cash sales of assets preceded, and roughly matched, the pay-outs at eighteen firms (44% of the subsample, overlapping with five of thecash-rich firms). There remains a group of thirteen firms who chose betweencash flows from operations and borrowing. Of these, five have relied entirely oncash flows from operations.145 The remaining eight have borrowed. The loansare funding the payouts in part at two firms, Time Warner, which is mixingborrowing with cash flows from operations, and California Coastal, where loanproceeds combine with ex ante cash. Borrowing funds the entire payout at theremaining six—Mylan Labs, Stilwell Financial, Blockbuster, CBRL, Acxiom,and A. Shulman.
The eight borrowers emerge from their payouts with financial profiles distinctfrom the other firms in the subsample. Two sets of ratios have been constructed:cash paid out to ex ante market capitalization, and debt (short- and long-term) toshareholders’ equity giving effect to the payout. (For announced but uncom-pleted payments, the ratios are constructed on a pro forma basis, utilizing thefirm’s most recent quarterly financials.) Figure IX compares the median andmean ratios for the nonborrowing and borrowing firms. The cash paid to marketcapitalization ratio measures the payouts’ magnitude relative to firm size, lettingus see whether resort to borrowing implies a bigger disgorgement. It does, by a
145. These are Time Warner, Temple Inland, New Century, PW Eagle, and Sylvan (which made acash distribution prior to going private). A seventh firm, Mirant, has announced a $1.25 billionrepurchase tender offer to be funded mostly by cash, with part of the funding to come from theproceeds of a subsidiary borrowing already under way. Mirant has not been included with theborrowing cases because it plans to sell the subsidiary after the borrowing is completed. In substance,then, its source of funds will be a combination of cash and asset sale proceeds.
2007] 1417HEDGE FUNDS AND GOVERNANCE TARGETS
small margin—the nonborrower median (mean) is 22% (16%) compared to theborrowers’ 29% (20%). A starker differential emerges with the debt to equitycomparison. The median (mean) borrower emerged with a debt to equity ratioof .94 (1.1), while the median (mean) nonborrower enjoyed a more comfortable.29 (.67).
It comes as no surprise that the activists responsible for three of the eightlevered capital structures, Carl Icahn (Mylan and Blockbuster) and Nelson Peltz(CBRL) are 1980s veterans. Even so, the figures show that hedge fund activismhas not been replaying the 1980s’ leveraged restructuring. Deals in the 1980stook firms to debt equity ratios of 5 to 1 or 10 to 1.146 Of the firms here, onlyone (CBRL) approaches that territory, with a ratio of 2.8 to 1.
Both the small number of leverage cases (19.5% of the payout firms) andthe relative moderation of the supporting borrowing call for an explanation.Three complementary factors can be suggested. First, lending standards,while loosening, remain stricter than they were two decades ago. Second,the payouts are determined in a context of bargaining under constraint. Bothsides weigh amounts against alternative courses of action. An activist thatrejects a payout as too low may have to take the case for a higher payout tothe shareholder group as a whole. There, the long-term shareholder interestwill ask whether the financial course advocated could injure the firm. Thisconstraint looms larger with larger targets, where the activist has less controlover the vote. Third, the activist retains its stock ex post in most cases in thepayout sample. The payout accordingly amounts to one phase of a broadercampaign of value realization, and sale of the target at a premium remainssalient as a possible end point. To the extent the class of potential buyers isexpected to borrow to finance the purchase of the target, present leveringimpairs the sale. Such impairment is particularly likely to follow withprivate equity purchasers.
When the results and the explanations are considered together with the factthat corporate cash retention lately has come to be viewed as a problem, thereresults an evaluation decidedly in favor of activist intervention.
D. PORTFOLIO RETURNS
Hedge fund activism, by its own terms, is about shareholder value creation. Aquestion accordingly arises about investment returns for the targets in thesample. Press reports on the activists’ profits suggest the existence of a disciplin-ary bonanza of historic proportions.147 One might question whether the stockprices of the firms in the sample support these expansive inferences. To answer
146. See JAMES C. VAN HORNE, FINANCIAL MANAGEMENT AND POLICY 727 (12th ed. 2001) (describingequity components of 10% in the late 1980s).
147. See, e.g., Jenny Anderson, An Appetite for Fast Gains from Restaurant Chains, N.Y. TIMES, Feb.10, 2006, at C7 (describing Pershing Square returns in 2005); Gregory Zuckerman, Big ShareholdersAre Shouting Ever Louder—Activists Pressure Executives To Unlock Value, Even Using Pirate, Bulldogin Their Monikers, WALL ST. J., Nov. 23, 2005, at C1 (describing returns at Icahn and Steel Partners).
1418 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
this question, a portfolio comprised of 104 firms from the sample has beenconstructed.148 Portfolio positions commence as of the filing date of the activ-ist’s SEC Form 13D, with the purchase price pegged at the average of the highand low purchase prices reported in the filing.149 Termination dates andprices are as follows: (a) for continuing holds, the closing stock price onDecember 31, 2006, (b) the effective date of the merger for sold targets orDecember 31, 2006, for pending mergers, in either case at the mergerprice,150 (c) for sold positions, the date of the Form 13D announcing salebelow 5% at the average of the high and low reported sale prices.151 Each ofthese investment positions is matched to a stock index position at the samestart and termination dates. The targets are divided into large-, mid-, andsmall-capitalization firms and paired accordingly with the S&P 500 Index,the S&P 400 Mid-cap Index, or the S&P 600 Small-cap Index. Returns arestated on the assumption that $100 was invested on the commencement date.Three subsamples are broken out: continuing holds, merged targets, and soldpositions.
It should be noted that this exercise is not directed to ascertaininginvestment returns at particular hedge funds. These cannot be determinedwith surety from public filings in any event—once a fund sells below 5%, itstrading results disappear from public view. Final returns to hedge fundinvestors are influenced by leverage and hedges, neither of which are madepublic. Also, this study is limited to domestic targets; the activists, incontrast, cross international borders. But we still can look at the prices ofthe firms in the sample to see whether hedge fund activists beat the marketin the aggregate.
Table VIII sets out aggregate results. The activists, for the most part, havefared better than the market portfolio alternative. For the full sample, thehedge fund portfolio returned an average 39% while the market portfolioreturned 27%; for the continuing holds, the largest sub portfolio, the hedgefund portfolio returned an average 48% to 31% for the market index. Thespread narrows considerably on the portfolios of merged and sold issues, toan average 25% over 22% for the merged companies and 26% to 16% forthose sold.
148. Uncertainty as to holding period or financial result resulted in the omission of ten firms.149. Where the filing reports no prices, the price is the consideration reported therein divided by the
number of shares purchased; where no 13D has been filed, the price is the market price on the date ofthe first press report. In the case of Kmart/Sears, the price is the closing market price on the date Kmartemerged from bankruptcy.
150. In pending stock mergers, the consideration is calculated based on the purchaser’s stock priceon June 30, 2006.
151. No 13D was filed to announce exit from Adelphia; resolving doubts in favor of the activist, thisdate has been pegged one week following the filing of the 13D. Nor was a 13D filed announcing entryand exit from Temple-Inland. Here the Icahn firm’s multiple entries and exits are ignored, and the datesare set at the target’s first and last appearance on the firm’s 13F portfolio reports.
2007] 1419HEDGE FUNDS AND GOVERNANCE TARGETS
Table VIII: Portfolio Results
Full Sample(104) Held (62) Merged (23) Sold (19)
Hedge Fund Mean(unweighted) 139 148 125 126
Index Mean 127 131 122 116
Hedge Fund Median 118 117 132 116
Index Median 119 123 120 116
Hedge Fund StandardDeviation 124 148 44 106
Index StandardDeviation 28 32 17 18
Mean Holding Period(months) 21 25 18 12
Hedge Fund Mean(weighted by marketcapitalization) 164 183 108 123
The hedge fund portfolio’s return takes a jump to 64% when recalculated asan average weighted by each issue’s market capitalization. This affords a fairerbasis for comparing it with market portfolio returns, which reflect a weightedcalculus. On a weighted basis, the best-performing portfolio in the sample is theportfolio of continuing hedge fund holds, which shows an 83% return on anaverage holding period of 25%, against the market portfolio’s 31%. Contrari-wise, the weighted hedge fund merger portfolio is the worst performer in thegroup at an 8% return over eighteen months. This fact implies that although themergers yield premiums over market price, the merged firms have tended toexperience antecedent stock market declines, with the declines cancelling outmost of the merger gain and perhaps also weakening firm managers’ bargainingposition with the activist. It bears noting that as of the end of 2006, no takershave been found for two targets in the held portfolio—Bally Fitness and PepBoys—despite public auction processes.152 A different story explains the betterreturn on the sold positions (23% over an average twelve months with highervolatility). This portfolio is made up of big winners and big losers; either way,the fund sells out.
The sets of returns for the hedge fund portfolios have higher standarddeviations than the market returns, signaling greater volatility of returns and ahigher required rate of return. To see how much higher, the portfolio of
152. See Jesse Eisinger, ‘Buy My Company, Please’: Why Some Companies Go Unsold in MergerBoom, WALL ST. J., Aug. 23, 2006, at C1 (citing James River Coal, to which the hedge fund later soldout at a loss).
1420 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
continuing holds has been analyzed within the Capital Asset Pricing Model.Five-year betas have been ascertained for seventy-two of the portfolio’s seventy-four issues of stock.153 The mean beta is 1.24 and the weighted average beta is1.37. Under the Model, using the long-term treasury return of 4.81% onDecember 31, 2006, and assuming a long-term market risk premium of 7%,154
the hedge fund portfolio should be returning 1.7% (unweighted) or 2.6%(weighted) more than the market portfolio’s expected return of 11.8%. On thismeasure the held portfolio still easily beats the index portfolio.
One further adjustment needs to be made, however. Two of the biggestwinners in the portfolio—Kmart/Sears and Martha Stewart—are friendly engage-ments. To get a clear picture of returns from hostile engagement, these and threeother friendly investments should be taken out. Their removal substantiallychanges the results for the full, held, and sold portfolios; the merged portfoliohas no friendly engagements. Figure X depicts the adjustment’s impact. It turnsout that Sears did matter for the weighted portfolio. Its removal reverses theoutcomes—now the market portfolio outperforms the unweighted hedge fundportfolio in all three samples and the weighted hedge fund portfolio for the fulland held samples; the weighted hedge fund portfolio only squeaks out a 3%edge for the sold portfolio. By this measure, the hedge fund portfolio must bedeemed suboptimal, at least as of December 31, 2006.155
153. Hoover’s is the source. Two companies have no betas: Del Global Technologies (because it ison the pink sheets) and Mirant (because it is recently out of bankruptcy).
154. See Ivo Welch, Views of Financial Economists of the Equity Premium and on ProfessionalControversies, 73 J. BUS. 501, 502 (2000) (reporting on a survey of financial economists).
155. To see if dividends made a difference, dividends paid were added to stock price results for theheld portfolio, calculated as of June 30, 2006. Returns increased as follows: unweighted from 142 to145, weighted from 155 to 158, and weighted for the hostile subset from 110 to 112. The results standaccordingly. Adding the dividends to the market comparisons would do at least this much.
A two-step weighting also was conducted, again as of June 30, 2006, taking into account the fact thatthe funds make smaller investments in large (median 6.7%) and mid-sized (mean 7.8%) than in
2007] 1421HEDGE FUNDS AND GOVERNANCE TARGETS
E. REGRESSION
The data in the sample invite analysis in search of statistically significantcausal relationships. Toward this end, the hedge fund portfolio results wererestated as annualized internal rates of return so as to be suitable as a dependentvariable in a multivariate regression analysis. Various governance results wereregressed against the portfolio results as dummy variables: settlement withoutboard membership, settlement with board membership, pressure–major conces-sion, pressure–minor concession, board membership through proxy fight, proxyfailure, pending, open, and board control. Prior performance against the indus-try was also regressed against the portfolio results. Only one variable provedeven weakly significant—settlement without board membership. But this didnot prove robust compared to alternative specifications such as taking thelogarithm of the internal rate of return.
F. SUMMARY
We have seen that indefinite term investments predominate in the sample andthat large cash payouts, while a salient result of intervention, have not crippledthe targets. Nor, except in one case, have we seen any destructive cost cutting;indeed, we have not seen much cost cutting at all. What we have seen is that itis not safe to assume that one would beat the market by investing in a portfolioof hedge fund targets.
In the picture that emerges, activist investment is a high risk/high returnenterprise. Nothing guarantees above-market returns when a hedge fund man-ager assembles a significant block of stock in a likely-looking company andthen gets on the phone with its managers and demands immediate value. Thelong-term winners will be those who play the game most skillfully, both asstock pickers and as management interlocutors. Some observers might at thispoint project a risk that players desperate for success at any cost will pile onunreasonable demands, thereby damaging their targets. While this could hap-pen, nothing requires target managers to increase their concessions in response.Cupidity drives the plays in a game like this one, whether or not the players beatthe market on average. The question is whether the cupidity is bridled orunbridled, and the constraints described in this Part suggest a bridle (or at least ahalter).
IV. HEDGE FUND ACTIVISM AND THE MARKET FOR CORPORATE CONTROL
Mergers and acquisitions figure prominently as occasions for activist interven-tion. As with Icahn and Mylan, intervention can occur against a firm in the
small-sized (9.6%) targets. The market capitalizations of each firm in the sample were weighted toreflect this difference (large: 27.8%; mid: 32.4%; small: 39.8%) before the calculation of weightedportfolio returns. The results for the portfolios improve very slightly after omitting friendly invest-ments: 110.4 for the full portfolio, 110.6 for the held portfolio, 103.9 for the merged portfolio, and115.5 for the sold portfolio.
1422 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
process of acquiring another firm, with the objective of terminating the transac-tion. Intervention can also occur against a firm being acquired, with the objec-tive of securing a higher price. Intervention often comes without a deal on thetable, with the objective of forcing the target to put itself up for sale. Finally, inMylan and a number of other cases in the sample, the intervening activist makesan offer to buy the target. These four points of intersection between hedge fundactivism and the market for corporate control raise two distinct policy ques-tions: First, whether activist disruption of management planning is more or lesslikely to have perverse effects with mergers than in other cases. Second,whether activism heralds a return of the hostile tender offer, reviving associatedpolicy questions with respect to target tender offer defenses.
Section A sets out the results from merger cases yielded in this Article’ssurvey. Section B traverses the problem of perverse effects, suggesting it to beminimal. Section C considers the activists’ offers to purchase, concluding thatno revival of the hostile takeover is in the offing.
A. THE SAMPLE
The database search brought up twenty-five cases, listed in Appendix B, inwhich a merger announcement triggered activist intervention. Nine of thetargets in this group are also included in the sample chiefly because the activiststayed on for an extended engagement after the merger transaction’s disposition.The other sixteen cases involve no overlap because there is no evidence offurther hedge fund engagement with the target.156
A taxonomic distinction follows. The sixteen additional cases involve share-holder intervention respecting a single transaction. Such sideline input fromWall Street has been a fact of life in the acquisitions market for three decades,generated by merger arbitrageurs seeking to make sure the target gets sold at themaximum possible amount. Most of the additional cases in the sample followthis long-standing motivational pattern. The cast of activist characters changesaccordingly, with firms like Perry Corporation and Elliott Associates showingup in addition to the activist firms that pursue longer engagements. The timehorizon changes also, with tighter focus on near-term gain.
A survey of the twenty-five listed transactions reconfirms the point that theactivists influence results. Only five transactions in the group closed with theirterms unaltered. Seven of the remaining twenty closed only after concessions,usually a price increase, with thirteen terminated entirely. Note that the formerresult will be pursued by a fund with a long position in the merger target, whilethe latter result will be pursued by a fund with a long position in the buyer.Funds with such opposing interests have come into open conflict in only two ofthe cases, however. In the rest, the funds show up on one side only, either asstockholders of the buyer seeking to terminate the deal (eight cases), or as
156. In one of these (Pharmacopeia/EOS Biotechnology), the objecting intervener was a long-terminvestor in the acquiring firm. There is no subsequent evidence of intervention, however.
2007] 1423HEDGE FUNDS AND GOVERNANCE TARGETS
stockholders of the selling firm seeking to get the deal’s terms improved (fifteencases).
Out of ten deals attacked on the buy side, only one deal closed untouched.Eight were terminated, and a ninth closed with the activist being conceded aboard seat. Six of these ten challenges fall in the subset overlapping the samplein chief. Buy side intervention, then, tends to implicate a diagnosis of gover-nance problems and a longer engagement, even though it can also implicate ashort term stock price gain achieved through deal termination. Sell side interven-tion is more likely to focus only on the transaction, as the intervener looks for ashort term gain through a price increase.
The sell side challenges have a broader range of results. Four of the transac-tions closed unaltered; four closed after price concessions; and three wereterminated in the wake of a higher offer from a third party. Five were terminatedwithout a higher bid on the table, implicating the loss of a premium, albeit apremium deemed too low. Significantly, four of these terminations occurred inthe overlap category, with activist pressure leading to a later sale in two of thefour cases. In a third case, the activist sits on the board of the unsold company.In the remaining two termination cases, an inside blockholder was attempting totake the firm private at an overly attractive price, leaving open an ongoingconflict with the public shareholders.
B. POLICY IMPLICATIONS
The corporate law of mergers and acquisitions devotes itself to assuring thatthe selling shareholders get a fair price, deploying fiduciary duties and appraisalrights to that end. While investors may object to the price in a particular deal, ina world where premiums range between 20% and 50%,157 no one deems sellingprices as amounting to a policy problem. The problem lies on the oppositeside—a fair selling price can mean an excessive purchase price. Corporate law,however, is more relaxed about fairness to buy side shareholders. In the usualcase, the board of directors’ decision to purchase lies in business judgmentterritory and appraisal rights are not obtained.158 At best, the dissatisfiedpurchasing shareholders have a vote,159 and hence a collective action problemin imposing their view that the deal is bad.
Many purchases turn out to be just that. The merger premium appears in mostcases to be so substantial as to arrogate the entire merger gain to the selling
157. See supra text accompanying note 63.158. DEL. CODE ANN. tit. 8, § 262(b)(1) (2001) (denying appraisal rights for shareholders of listed
companies and shareholders not entitled to vote on the merger).159. But not in all cases. See DEL. CODE ANN. tit. 8, §§ 251(c),(f) (2001) (providing for a shareholder
vote unless, inter alia, the number of new buyer shares issued in the merger exceeds 20%). A buyer canget around the vote by organizing a subsidiary corporation to conduct the transaction. Stock exchangerules constrain this move, however. See N.Y. STOCK EXCHANGE LISTED COMPANY MANUAL § 312.03(2004) (requiring a vote in any case where the number of buyer shares increases in an amount equal toor greater than 20%).
1424 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
shareholders. Studies of announcement period price effects bear out this asser-tion with a stark allocational picture. While the selling firm’s shares go up aconsistent 16% during the three days surrounding an announcement, the purchas-er’s shares go down—the average was -0.3% in the 1970s, -0.4% in the 1980s,and -1.0% in the 1990s.160 Over a time window of several months, target sharesaverage an increase of 23.8%, while buyer shares on average go down around4%.161 The figures imply consistent losses to buy side shareholders.
A reference to portfolio theory makes the results less disturbing. Mostpurchasing firm shareholders own their shares in diversified portfolios. Thus,they stand on both sides of the deal and so are indifferent to the division of gainas between the parties to the deal.162 So long as the combined result for the twofirms nets out positive, everything is fine. And such was the overall case untilthe late 1990s: from 1973 to 1998, the combined three day window resultaveraged a positive 1.8%; from 1980 to 1989, the average was 2.6%; and from1990 to 1998 the figure was 1.4%.163
Unfortunately, a cluster of mergers in the late 1990s reversed the 1.8%long-term positive. Moeller, Schingemann, and Stulz marshal some shockingthree-day announcement returns. They show that from 1980 to 1990, purchasingfirms’ shares lost an aggregate $4 billion, and from 1990 to 1997 they gained$24 billion. From 1998 to 2001, however, they lost $240 billion, bringing downthe 1990 to 2001 result to a $216 billion buyer loss. The 1998 to 2001 numbersare so bad that they make for a negative combined result of $134 billion forbuyers and sellers in the period.164 The negative dominoes fall from there.Where in the 1980s combined returns were a positive $12 billion, from 1991 to2001 the combined loss was $90 billion.165 That nets out to a $78 billion lossfor 1980 to 2001.166
160. Gregor Andrade, Mark Mitchell & Erik Stafford, New Evidence and Perspectives on Mergers,15 J. ECON. PERPS. 103, 109–10 (2001).
161. Id. The decline was -4.5% in the 1970s, -3.1% in the 1980s, and -3.9% in the 1990s. Id. Thereis literature that sorts for the characteristics of bidder firms with low abnormal returns. The results aresummarized as follows: abnormal returns are lower for (1) low leverage firms, (2) low Tobin’s q firms,(3) firms with large cash holdings, (4) firms with low managerial ownership of shares, and (5) largecapitalization firms. Sara B. Moeller, Frederick P. Schlingemann & Rene M. Stulz, Wealth Destructionon a Massive Scale? A Study of Acquiring-Firm Returns in the Recent Merger Wave, 60 J. FIN. 757, 770(2005). Lower abnormal returns are also associated with certain transactions: (1) public firm targets, (2)target opposition, (3) conglomerate results, (4) competitive bidding, and (5) stock consideration. Id. at770-71.
162. Robert G. Hansen & John R. Lott, Jr., Externalities and Corporate Objectives in a World withDiversified Shareholders/Consumers, 31 J. FIN. & QUANTITATIVE ANALYSIS 43, 47 (1996) (noting that aninvestor holding a diversified portfolio with stock in both corporations is concerned with the total gainfrom the transaction, not with how the gain is allocated).
163. Andrade, Mitchell & Stafford, supra note 160, at 110.164. Moeller, Schlingemann & Stulz, supra note 161, at 758–59.165. Id. at 763.166. These disastrous results stem from eighty-seven deals out of a total of 4,136 in the authors’
sample. Id. at 765. The most prominent common feature among the purchasing firms involved was prioracquisition behavior. The purchasing firms are serial acquirers with high market valuations. In the past
2007] 1425HEDGE FUNDS AND GOVERNANCE TARGETS
Herein lies a great potential for the activists to do some good, just byenhancing the chance of shareholder disruption of a friendly merger. Themanagers of a potential buyer now have to worry about attack on two fronts.Complaints by dissatisfied selling shareholders (and the fiduciary duties of theseller’s managers) continue to increase the likelihood of renegotiation for ahigher price or the appearance of a third party with a higher offer.167 But nowthe buyers’ own shareholders may be in a position to register their objectionseffectively, with the objection implying a credible threat to the firms’ businessplan and the incumbency of its managers. Prudent managers accordingly willtake more care in selecting, structuring, and pricing their transactions.
The question arises whether intimidated managers will be deterred fromentering into beneficial combinations. This seems highly unlikely for threereasons: First, because deal pressure arises within industries, managers proac-tively look for acquisitions as means of self-defense. Second, the markets arefull of intermediaries who add to deal pressure in order to generate fees. Third,the markets are also full of institutional investors looking for sell-side premi-ums, the hedge funds prime among them. Note that the balance of pressure inthe sample lies squarely on the selling side. Even when an activist intervenes toterminate a purchase, it often does so for the purpose of turning the buyer into aseller. One suspects that buy/sell standoffs, as in Mylan, will not occur veryoften. But, when they do, we should not presume them to be harmful.
C. ACTIVISTS AS PURCHASERS
Commentators on hedge fund activism project an evolution toward hostiletender offers.168 This projection makes sense. The distinction between hedgefunds and private equity becomes less and less clear as hedge funds enter intothe bidding for companies going private. At the same time, the hedge funds donot share private equity’s reputational interest in cooperative engagement. Putthe two points together, and hedge fund activism finally ripens into a replay ofthe hostile takeover boom of the 1980s.
Although the projection makes structural sense, it finds little support in thesample. The activists have indeed made offers to purchase. Recall that CarlIcahn put an offer on the table in Mylan, only to withdraw it upon achieving theobjective of a large cash payout. Offers were also made in seventeen other casesin the sample in chief.169 This time Icahn’s case is typical. None of the eighteenoffers has led to a merger. Although the offers are “hostile,” only three resulted
they had made value enhancing acquisitions. Moeller, Schlingemann, and Stulz suggest that the patternof success caused an increase in the managers’ zone of discretion. The managers then push theacquisition pattern too far and the market withdraws its support. Id. at 760, 777.
167. See Shearer, supra note 15.168. See Shearer, supra note 68; Fishman-Lapin, supra note 15.169. They are MaxWorldWide, TCSI, Gyrodyne, Footstar, GenCorp, Wells Financial, General
in a filing of a formal SEC Form TO (General Motors, Acxiom and Whitehall).Two of the three, Kirk Kerkorian’s tender for General Motors stock and ValueAct’s tender for Acxiom, should be put to one side. Kerkorian’s GM offer,although not only initiated but closed, served only to increase the offeror’s 3%ownership stake to 7.2%, not to secure control of the firm.170 Value Act’s offer,now withdrawn after a settlement, was similar—it would have increased itsstake from 11.7% to 19.9% of the stock and was conditioned on its slate beingelected in an upcoming election.171 Whitehall was different. There the hedgefund eventually submitted a bid at an auction conducted by the target. The samething happened in one other case (Beverly). But both times the hedge fund justhappened to have been beaten by a slightly higher offer ($0.10 and $0.30,respectively). Nor have their offers on the whole been generous, with a medianpremium of 20%. In one case (Circuit City) the press commented that the offerwas a transparent ploy to put the company in play172 so that someone elsewould take it over. The same point seems appropriate in the other cases. Theploy has succeeded in four (MaxWorldWide, TCSI, Beverly, and Whitehall).Significantly, it did not succeed in the other thirteen cases. An offer remains onthe table in one of these (Houston Exploration). In the rest, the offer to purchasefaded out as the engagement took its course.
D. SUMMARY
The activists come to the merger market on both sides of the transactions. Onthe sell side, they augment standing pressure for higher premiums. On the buyside they interject a welcome note of resistance, forcing acquiring firms to takemore care against overpaying. As yet, there is no sign of a revival of the hostiletender offer.
CONCLUSION
This Article’s survey of activist intervention rebuts two allegations made bythe hedge funds’ critics. The interventions neither amount to near-term holdupsnor revive the 1980s leveraged restructuring. Today’s pattern is more moderatethan that of twenty years ago. Engagements in the 1980s tended to have all ornothing outcomes—either the activist took over the firm, the firm went privateor otherwise paid off its shareholders with the proceeds of a leveraged restructur-ing, or the firm stayed independent, perhaps after making a greenmail payment.Today’s activism triggers changes in control in only a minority of the cases;when control does change it tends to mean a sale to a third party rather than tothe activist. Today’s cash payouts, while substantial, do not imply radicaltransformations of the targets’ capital structures. Today’s activists often use their
170. See General Motors Corp. (Schedule TO/A), at 2 (July 20, 2005) (filed by Tracinda Corp.).171. See Acxiom Corp. (Schedule TO-C) (June 21, 2006) (filed by VA Partners LLC).172. Andrew Ross Sorkin, They’re All Paying Customers to Wall Street, N.Y. TIMES, Dec. 11, 2005,
§ 3, at 5.
2007] 1427HEDGE FUNDS AND GOVERNANCE TARGETS
power to acquire board seats, as occurred in 40% of the sample’s hostile cases.This is the survey’s most interesting result: With boardroom entry come
fiduciary duties to the entity as a whole and an implicit commitment to pursuethe value agenda in a cooperative framework, much as Warren Buffett hasalways done. At the same time, the activists’ independence and financial stakesimply a more critical stance toward management initiatives than heretoforeforthcoming from outside directors. The activists thereby present a new varia-tion on the blockholder theme, more distanced from management and arguablybetter positioned to approach corporate governance’s theoretical ideal of avigorous outside monitor. Whether the activists succeed in mediating betweentheir agendas as fund managers and as boardroom fiduciaries remains to beseen. Meanwhile, they conduct an important experiment in corporate gover-nance.
Two other results coexist in tension. On the one hand, the activists’ record ofgovernance success is impressive enough to support the proposition that theyhave shifted the balance of corporate power in the direction of outside sharehold-ers and their financial agendas, perhaps heralding a modification of the prevail-ing description of a separation of ownership and control. On the other hand, thestock portfolio comparisons, taken together with the changing financial andperformance characteristics of the targets, cast doubt onto the existence offinancial incentives sufficient to support a significant alteration of the gover-nance equilibrium. The tension can best be resolved with a warning that toomuch should not be made of either result. We will see more cases likeMcDonald’s as managers move up the learning curve. At the same time, theportfolio results are just a market snapshot as of the close at the end of 2006.Note that continuing positions make up the largest and best performing of thethree portfolios. In every one of those cases, the activist, by hypothesis, hasdetermined that the stock price does not yet reflect the firm’s intrinsic value; hadit thought otherwise, it would have sold and disengaged from a governance roleat the target. For financial results speaking to incentives, we must wait for thelong-term. That only makes sense—as the survey shows, hedge fund activismdoes not tend to be a short term enterprise.
The portfolio results may have meaning for the short term, however. Theysignal that corporate governance has not left twenty dollar bills lying on WallStreet to be picked up by any portfolio manager who looks down. The newshareholder activism, although distinguished by its combination of a valueperspective and impatience, turns out to call for patience and skill. The predic-tion is not that incentives are lacking, but that some practitioners will do muchbetter than others.
1428 [Vol. 95:1375THE GEORGETOWN LAW JOURNAL
APPENDIX A: GOVERNANCE INTERVENTION SAMPLE
Company Year Hedge Fund
Maximum percentowned (*reporting
group)
Pizza Inn Inc. 2002 Newcastle Partners 40.8
Reader’s Digest 2002 Highfields Capital Mgmt. 9.19
MeVC Fund 2002 Millennium Partners 7.18
Vista Bancorp 2002 Seidman Associates 12.5
Martha Stewart Living 2002 ValueAct Capital 22
Penn Virginia 2002 BP Capital Energy(Boone Pickens)
14.7
Brantley Capital 2002 Philip Goldstein 6.7
Autodesk 2002 ValueAct Capital 4
MaxWorldWide 2002 Newcastle Partners 11.5
Liquid Audio 2002 Steel Partners II 17.6
SL Indus. 2002 Steel Partners II 28.6
Sylvan Inc 2002 Steel Partners II 9.6
Del Global Technologies 2002 Steel Partners II 7.6
TCSI 2002 Newcastle Partners 12.8
Stilwell Fin. Inc. (Janus) 2002 Highfields Capital Mgmt. 8.9
Alliance Bancorp of NE 2002 Lawrence Seidman 6.2
Adelphia Communications 2002 Highfields Capital Mgmt. 9
Heidrick & Struggles Int’l 2002 Eminence Capital 11.29
Gyrodyne Co. of America 2002 K Capital 18.72
Aspect Communications 2003 Scepter Holdings 6.6
Kmart 2003 ESL Partners 52.6
Potlatch Corp. 2003 Franklin Mutual Advisors 15.5
Nautica 2003 ESL Partners 9.55
Sears 2003 Barington Partners 9.5
Intercept Inc. 2004 JANA Partners 7.1
Footstar Inc. 2004 Chapman Capital 7.1
Farmer Bros. 2004 Franklin Mutual Advisors 13
Angelica Corp. 2004 Cannell Capital 19.6
Warwick Valley Tel. 2004 Santa Monica Partners 2.1
Bally Total Fitness 2004 Liberation Inv. Group 11.2
Steven Madden Ltd. 2004 Barington Capital Group 7.59
